Procyclical Fiscal Policy

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During economic downturns, policymakers can take two approaches to address the lack of economic growth. While Keynesian economists support a countercyclical approach by lowering interest rates and injecting liquidity into the economy, proponents of Friedrich von Kayek support a procyclical fiscal policy. This method entails accepting the market conditions as self-correcting during downturns and being fiscally cautious during boom times.

Identification

A procyclical fiscal policy is one that works with the natural swings of the economy instead of attempting to rectify the downturns. An example of these policies is supporting low taxes and interest rates during times of high spending and economic surplus and raising them during steep recessions. As chairman of the Federal Reserve, Paul Volcker implemented procyclical fiscal policies in the early 1980s when he raised the interest rate to nearly 20 percent as a way to eventually improve the dismal economy and prevent runaway inflation. Procyclical economists also slash services and excess spending to meet deficits, as Margaret Thatcher did in Great Britain during the 1980s. T. Nagakawa, author of the book, “Business Fluctuations and Cycles,” explains these advocates view recessions as an opportune time to purge the economy of unproductive, inefficient firms.

Short-Term Effects

In the short run, the effects derived from a procyclical fiscal policy during boom times and downswings are enhanced, for better and for worse. Low taxes and interest rates encourage consumption, thereby promoting robust economic activity and growth. Conversely, high taxes and interest rates exacerbate stunted growth and a stalled economy. The short-run effects of a countercyclical fiscal policy are improving an ailing economy during a recession, in part by boosting consumer confidence.

Long-Term Effects

In the long run, the effects are debated. A procyclical policy expert believes any improvements to the economy post-recession are because of stringent budgeting and lack of deficit spending. In Europe, for instance, Germany mandated that Greece implement procyclical austerity measures to solve its debt crisis instead of relying on bailouts. In 2011, Greece’s prime minister also suggested ratings agencies depart from procyclical policies of encouraging borrowing with high ratings during good times and downgrading debt, thereby exacerbating the debt problem during recessions. On the other hand, countercyclical fiscal policies believe the negative long-term effects of its short-term policies never come to fruition. Instead, solving problems in the short run is believed to offset long-term issues that may or may not happen.

Effectiveness

The effectiveness of procyclical policies depends on the view of the economist. Using the example of Volcker’s actions of raising interest rates, it could be argued this action prevented hyperinflation from ravaging the economy or that the policies threw the U.S. into a recession. Likewise, procyclical economists argue Federal Reserve Chaiman Ben Bernanke’s countercyclical policies of flushing money into the economy with quantitative easing programs devalue the dollar and worsen the budget woes.

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