Philip Arestis and Malcolm Sawyer

The return of fiscal policy

Abstract: This paper examines the implications of the experience with the fi-
nancial crisis of August 2007 for fiscal policy and the use made of it. We briefly
sketch the changing attitudes toward fiscal policy and the demise of arbitrary
rules for the budget deficits and the reassertion of purposeful fiscal policy, that
is fiscal policy for the purpose of helping to create the conditions for high levels
of employment. Instead of a focus on debt overall, there should be consideration
of the net balance sheet position. It is often argued that running a budget deficit
places upward pressure on interest rates. We argue that in the context of the use
of “functional finance,” the ability of the deficit to in effect fund itself removes
any underlying upward pressure on interest rates. We also deal with the issue
of balance-of-payments constraints, and argue that under such circumstances
the appropriate policy response is not to forgo fiscal policy but rather to tackle
the balance-of-payments constraint.

Key words: budget deficits, fiscal policy, functional finance.

We have been arguing for a number of years that fiscal policy would be a
more potent policy tool than monetary policy (Arestis and Sawyer, 2003)
and that the arguments that fiscal policy was impotent were not valid
(Arestis, 2009a; Arestis and De Antoni, 2009; Arestis and Sawyer, 2006b;
Sawyer, 2009). The purpose of this paper is to consider the implications
of the experiences of the financial crisis and the use made of fiscal policy.
The section that follows this short introduction attempts to briefly sketch
the changing attitudes toward fiscal policy. And attitudes have changed
following the events post August 2007, especially after the collapse of

Philip Arestis is Honorary Senior Departmental Fellow, Cambridge Centre for Eco-
nomic and Public Policy, Department of Land Economy, University of Cambridge;
and Professor of Economics, Department of Applied Economics V, University of the
Basque Country. Malcolm Sawyer is a professor of economics in the Economics Divi-
sion, Leeds University Business School at the University of Leeds. An earlier version
of the paper was presented at the Sixth International Conference on Economic Theory
and Policy (Bilbao, July 2009). The authors are grateful to the conference participants
and to three referees for helpful comments. The usual disclaimer applies.

Journal of Post Keynesian Economics / Spring 2010, Vol. 32, No. 3   327
© 2010 M.E. Sharpe, Inc.
0160–3477 / 2010 $9.50 + 0.00.
DOI 10.2753/PKE0160-3477320301
328 JOURNAL OF POST KEYNESIAN ECONOMICS

Lehman Brothers in September 2008. The first part of the discussion in

sections that follow concerns the demise of arbitrary rules for the budget
deficit (third section), and the reassertion of the approach to fiscal policy,
which can be described as “functional finance” (Lerner, 1966: Nell,
1998) and purposeful fiscal policy, that is with the purpose of helping to
create the conditions for full employment (fourth section). A feature of
the policy responses to the financial crisis has been the degree to which
governments have acquired financial companies and have been engaged
in forms of “bailout.” These have led to a substantial increase in public
debt.1 But, in general, in these operations, the government also acquired
assets, and depending on the price paid and the future profitability of the
assets, could mean that the government’s net wealth position has improved
(clearly if the value of assets acquired turns out to exceed the price paid).2
The argument developed in the fifth section is that government should
focus on its net balance sheet position rather than its liabilities alone.
The implications of that argument are then examined.
It is often argued that running a budget deficit places upward pressure
on interest rates, whereas in contrast we argue that in the context of the
use of “functional finance,” the ability of the deficit to in effect fund itself
removes any underlying upward pressure on interest rates. We do, though,
in the sixth section consider when there may be some temporary effects of
expansion of public expenditure on interest rates. Having a budget deficit
may well involve not just domestic borrowing by government but directly
or indirectly borrowing from overseas. There have been fears expressed
that governments, particularly in developing countries, cannot use fiscal
policy because of the implications of budget deficits for the balance of
payments and the exchange rate. In the seventh section, the argument
is developed that insofar as there are balance-of-payments constraints,
these would come into play for any policy designed to bolster the level
of demand, and that the appropriate policy response is not to forgo fiscal
policy but rather to tackle the balance-of-payments constraint.

1 For example, the nationalization of Northern Rock and other relative small finan-

cial institutions in the United Kingdom would increase public-sector debt by nearly
one quarter (“Budget 2009: Building Britain’s Future,” 2009, table C.14), and that
figure includes interventions over the Royal Bank of Scotland (RBS) and Lloyds
Banking Group.
2 It should be noted that there were cases where governments acquired preferential

shares that they were committed to sell back at the price which they paid for them. In
such cases, although no capital gain will be realized, the rate of interest paid on the
preferential shares has been rather high.
 The Return of Fiscal Policy  329

Changing attitudes toward fiscal policy

The general (“conventional wisdom”) approach to fiscal policy over
the past two to three decades could be summarized along the following
three propositions:
(1) Monetary policy was the major instrument for macroeconomic
management (generally targeted on inflation), and fiscal policy had at
most a supporting role in terms of providing an element of an automatic
stabilizer, which could dampen down the swings in economic activity.
This was reflected in the formulation of the “new consensus in macro-
economics” (Meyer, 2001; Woodford, 2003; see also Arestis, 2009b, for
a critical appraisal), which in a widely used three-equation formulation
made no explicit mention of fiscal policy. It included, instead, a monetary
policy rule for the setting of interest rates, which in turn had effects on
demand and thereby inflation.
(2) Appeal was made to Ricardian equivalence arguments to the effect
that fiscal policy and budget deficits would be impotent in affecting the
level of economic activity in that the effects on aggregate demand of
increases in government expenditure or decreases in tax rates would be
exactly offset by changes in private demand. Further ideas of the benefits
of fiscal consolidation to the effect that a policy announcement to reduce
budget deficit would have favorable effects on confidence, which would
stimulate investment and consumer expenditure were much in evidence
(see Arestis, 2009a, for a comprehensive summary and critique).
(3) The argument that the use of fiscal policy encouraged profligacy
and budget deficits would lead to unsustainable public debt. In an at-
tempt to limit those tendencies, variants of balanced budget rules were
advocated. A clear example of this is the intention of the Stability and
Growth Pact of the Economic and Monetary Union (euro area) for in-
dividual countries to have a budget position in balance or small surplus
over the business cycle subject to a 3 percent of gross domestic product
(GDP) limit in any year.3 It is also reflected in the 60 percent ratio of
debt to GDP imposed by the Stability and Growth Pact (though the broad
balance of deficit and 60 percent debt ratio are inconsistent in that); for
example, a 60 percent debt ratio would be compatible with a deficit of an
average around 3 percent of GDP (with an assumed growth of nominal

3 In the event, a number of countries in the euro area broke the 3 percent limit rule

(Arestis and Sawyer, 2006a), and it is debatable whether even prior to the financial
crisis the UK government was meeting the “golden rule” (see, e.g., Sawyer, 2007).
330 JOURNAL OF POST KEYNESIAN ECONOMICS

GDP of 5 percent per annum).4 The “golden rule” adopted by the UK

government combined the intention to balance the current budget over
the cycle with an upper limit on public debt of 40 percent of GDP (which
could be seen to imply a deficit of the order of 2 percent of GDP to pay
for capital expenditure).5
There is a sense in which governments always have to conduct fiscal
policy in that they have to adopt expenditure plans and tax policies, which
have implications for the budget deficit and for the level of economic
activity. The more significant aspect is whether fiscal policy is directed
toward some form of balanced budget or whether it is directed toward
variation in the balance between expenditure and revenue intended to
influence the level of demand and to respond to changes in private ex-
penditure. Fiscal policy has in recent decades been reduced to a role of
aiming for some form of balanced budget though generally recognizing
that the budget position would vary cyclically (deficit rising in a downturn,
falling in an upturn) with some stabilizing properties.
But in practice, governments often pursued fiscal policy involving large
movements in the budget position, which have, perhaps inadvertently,
stimulated the economy. The Bush fiscal package of 2001 was a notable
example, which has involved a continuing budget deficit since. Godley et
al. speak of “the huge relaxation in fiscal policy 2001–03 (in the USA),
probably amounting to some $700 billion, which unintentionally (i.e.,
not as part of any strategic plan) staved off the worst of the recession that
took place at that time as a result of the dot-com crash)” (2008, p. 1).
Similarly, we have argued (see Sawyer, 2007) that the United Kingdom
had fortuitously adopted a fiscal policy, which involved a large swing in
the budget position (in cyclically adjusted terms from a surplus of 1.4
percent of GDP in 1999–2000 to a deficit of 3 percent of GDP in 2004–5).
Interestingly enough, that fiscal policy helped support aggregate demand
and economic activity subsequently.
The responses in terms of fiscal policy to the financial crisis and re-
cession in late 2008 and early 2009 were remarkable in two respects.
First, there were no attempts in any of the large countries to strive for a
balanced budget (in contrast with budget policy responses in the 1920s
and 1930s) by reducing expenditure or increasing taxation. Some small
countries, however, such as Ireland and Latvia, have adopted policies
4 The general formula is that for the government debt to GDP, b would stabilize at

d/g, where d is the deficit-to-GDP ratio and g is the (nominal) growth rate. With the
assumption of a nominal growth rate of 5 percent, 60 percent debt ratio, and 3 percent
deficit ratio are mutually compatible.
5 See the formula in note 4.
 The Return of Fiscal Policy  331

designed to reduce public expenditure, raise taxes, and overall reduce the
budget deficits. In a related vein, it is also remarkable that a number of
governments (perhaps most notably the UK government) have dropped
adherence to (previously self-imposed) deficit or debt constraints. Sec-
ond, there has generally been a sharp change in attitude toward the use of
discretionary fiscal policy and increases in the budget deficit even though
budget deficits were already rising through the effects of the recession.6
A welcome feature of policy responses to the financial crisis has been
the speed with which fiscal policy (stimulus) has been brought into play.
However, having said all that, it is rather doubtful whether a paradigm
shift has occurred. We may cite as an example of this argument the Euro-
pean governments, which have dealt with this crisis as a crass exception
that makes extraordinary measures necessary, only to return to normal
once the crisis seems to have evaporated (see, e.g., OECD, 2009).

The demise of arbitrary budget rules?

The view that the government should seek to always balance its budget
(on an annual basis) finds little support with the realization that in the face
of a downturn, which leads to lower tax revenue and higher government
expenditure, seeking to balance the budget would be counterproductive.
But, as indicated above, rules on budget deficits have become common-
place with a combination of rules to balance some form of budget over
the cycle and attempts to ensure that a deficit (or surplus) in any specific
year is consistent with that aim of a balanced budget over the cycle.
The recent experience with upgrading fiscal policy and promoting fiscal
stimuli in the face of the financial crisis has shown that rules have to be
suspended and that arbitrary budget deficit rules can interfere with poli-
cymaking. There have been previous examples, though not as dramatic,
when budget deficits exceeded the rules of the Stability and Growth Pact
(see, e.g., Arestis and Sawyer, 2006a). Budgetary rules, which specify
some form of balanced budget, are viewed as arbitrary unless there are
strong reasons to believe that a balanced budget will be consistent with
the desired level of economic activity.

6 In the United Kingdom, the fiscal stimuli amounted to the following changes and

predictions (as a percentage of GDP): budget deficit to GDP: –3.1 percent (2008–9)
from –0.7 percent (2007–8), rising to –6.7 percent (2009–10), and thereby falling
to –6.4 percent (2010–11); debt to GDP: 43 percent (2008–9) from 36.5 percent
(2007–8), rising to 55.4 percent (2009–10), 65 percent (2010–11), and 74.5 percent
(2011–12), before peaking at 76.2 percent (2013–14).
332 JOURNAL OF POST KEYNESIAN ECONOMICS

Targets have also often been set for the size of the public debt rela-
tive to GDP—for example, 60 percent under the Stability and Growth
Pact of the European Monetary Union (EMU), 40 percent in the United
Kingdom.7 These types of figures are also quite arbitrary, and as far as
we are aware little justification has been advanced to justify them—for
example, why 40 rather than 50, why 60 rather than 100? As discussed
below, the intertemporal budget constraint would impose the condition
that the government–debt ratio tends to zero. We will also come back to
the point that the limits on debt are placed on gross financial liabilities
(rather than on, e.g., net worth).
What was labeled as the (UK) “Treasury view” argued for seeking to
balance the budget in each calendar year.8 The realization that fluctuations
in the private sector generate fluctuations in tax revenues (and to some
degree movements in public expenditure in the form of transfer pay-
ments), and hence in the budget deficit, has generally led to an acceptance
of such movements in the budget deficit and the avoidance of measures
seeking to reduce the budget deficit when it rises in economic downturns
(and reduce budget surplus when it rises in upturns). This implies that
variations in the budget deficit arise from variations in private-sector
activity and would arise even in the absence of variations in tax rates or
public expenditure. It would then seem a recognition that there can be
temporary shortages of aggregate demand, albeit offset by temporary
excesses of aggregate demand at other times and perception of a general
adequacy of aggregate demand. What is not explained is why aggregate
demand fluctuates and how it can be that aggregate demand is necessarily
sufficient over the long haul but not sufficient in the short term.
If the view is taken that individuals are subject to a binding budget
constraint and that individuals are nonsatiated in their consumption, then
it follows that individuals will spend up to their budget constraint. Hence,
all income is spent, and there is no aggregate demand issue. Introducing
savings and investment into the picture, of course, allows for a disjuncture
between the desire to save and the desire to invest, and Post Keynesians
would emphasize the driving role of investment and the way in which
output and employment would adjust to bring savings and investment

7 The way the debt is measured differs between the two cases; hence, the two fig-

ures quoted are not directly comparable.

8 The UK “Treasury view” was proposed initially in the 1920s (see, e.g., Hawtrey,

1925) but was advanced and implemented in the 1930s, during the Great Depression,
by the UK Chancellor of the Exchequer. Simply put, this view argues that fiscal policy
does not have any effect on economic activity. Neither government expenditure nor
tax changes can affect the level of economic activity.
 The Return of Fiscal Policy  333

into equality. But the mainstream view relies on the rate of interest to
balance savings and investment—in effect, the postulate of a “natural
rate of interest,” which balances the “forces of productivity and thrift”
(Woodford, 2003). Provided that the central bank is able to achieve the
“natural rate of interest,” there is no issue of divergence between (desired)
investment and savings. Specifically, there is no suggestion that there will
be differences between savings and investment, and hence inadequate or
excess aggregate demand in any time period.
The question is, then, whether the central bank is in a position to
achieve the “natural rate of interest.” A shift in the state of confidence
and expectations leading to a shift in the investment schedule would lead
to a change in this rate. In Arestis and Sawyer (2008a), we show that any
“natural rate of interest” would be defined for a specific fiscal stance,
specific world demand, and specific set of “animal spirits” influencing
investment, in addition to preferences and technology. Another example
is the study by Laubach and Williams (2001), where it is demonstrated
through the use of the Kalman filter technique that the “natural rate of
interest” estimates vary “one-to-one” with changes in the trend growth
rate of potential output. As the factors suggested in these studies vary,
so will the real rate of interest. Consequently, there is the real difficulty
and uncertainty that relate to establishing robust estimates of the “natural
rate of interest.” Furthermore, the “natural rate of interest” should be
readily computable from actual economic data. However, Weber et al.
(2008) demonstrate persuasively that there are serious problems with it.
The empirical estimates for the “natural rate of interest” are extremely
imprecise, so that this rate of interest “is not readily computable from
observable economic data” (ibid., p. 13). There is also the problem that
any cost–push shock is a significant source to inflation and an important
element of inflation information to monetary policymakers; but it “is not
mirrored by the natural rate of interest” (ibid., p. 13). This problem is
prevalent whichever method may be used for estimating the real equi-
librium rate of interest. In Arestis and Chortareas (2008), a time-varying
measure of the “natural rate of interest” is arrived at, which responds to
preferences and technology shocks and as such it is time varying. If there
were a “natural rate of interest,” which the monetary authorities could
persistently achieve even if it changed over time, then desired savings
and investment would be equal at the supply-side equilibrium, and there
would be no need for fiscal policy. But in the absence of that condition,
fiscal policy is required to maintain high levels of demand.
In many cases in the crisis, budget rules along the lines of balancing
the budget over some time frame have been suspended. The argument
334 JOURNAL OF POST KEYNESIAN ECONOMICS

in this section is that since the underpinnings for such rules are lacking,
then that suspension should be made permanent.

Fiscal policy for a purpose

There should be rules for the conduct of fiscal policy, and those rules
should be based on the ideas associated with “functional finance”
(Kalecki, 1944; Lerner, 1966). Lerner argued for a “functional finance”
approach that “rejects completely the traditional doctrines of ‘sound fi-
nance’ and the principle of trying to balance the budget over a solar year
or any other arbitrary period” (1966, p. 355). But fiscal policy has a func-
tion, which is to ensure a high level of aggregate demand, and from that
function rules can be developed. The rules are derived from the principle
of seeking to set the budget deficit to support aggregate demand at the
target level: subject to supply constraints and lack of productive capacity
in the economy, the target level should be consistent with full employment
(see, e.g., Arestis, 2009a; Arestis and Sawyer, 2006a, 2008b).
The rule can be readily represented. It should seek to have a budget
deficit such that
G – T = S(YT) – I(YT) + Q(YT) – X, (1)
where G is government expenditure, including transfer payment and
interest; T is tax revenue; S is private savings; I is (private) investment; Q
is imports; and X is exports. The target level YT is included to remind us
that the relevant variables depend on income. It should be firmly kept in
mind that these variables will depend on many others. Most importantly,
the distribution of income between wages and profits and the exchange
rate would be significant variables, and factors such as the state of ex-
pectations and confidence have key roles. The difficulties of making the
correct calculations should not be minimized, but similar difficulties arise
when striving to meet other rules (such as balanced budget). The govern-
ment does not, of course, directly set the budget deficit but rather sets tax
rates and expenditure plans from which the actual budget deficit emerges,
which, of course, will differ from the predicted budget deficit.
A major advantage of the pursuit of a “functional finance” approach is
that a budget deficit is only required (on the left-hand side of the equa-
tion) when there is some combination of desired net private savings and
capital account inflow. The budget deficit permits net private savings to
occur, which thereby provides the funding of the budget deficit. A fiscal
policy operated along these lines does not run into issues of funding
for the deficit (Arestis and Sawyer, 2010). Any increase in expenditure
 The Return of Fiscal Policy  335

has to be financed and government expenditure is no exception. But the

“functional finance” view is that in the circumstances described above, the
budget deficit can be funded—that is, after the expenditure has occurred,
there will be sufficient savings to provide the funds for the deficit.
The focus of budget decision making has been on the balance between
expenditure and tax revenues with relatively little attention given to the
distinction between current expenditure and capital expenditure. Further,
attention is paid to the outstanding government debt (e.g., debt targets
under the Stability and Growth Pact are set in liability terms). For the
purpose of the “functional finance” argument, the distinction between
current and capital expenditure is not particularly relevant for what
matters is the amount of expenditure. For the operation of fiscal policy
(particularly relevant in the current circumstances), how quickly the
expenditure can be varied becomes relevant.
The sustainability of a budget deficit depends on the level of inter-
est rates (and specifically the posttax rate of interest on government
bonds, labeled r). If r < g, then any primary budget deficit of d (relative
to GDP) would lead to an eventual debt ratio (to GDP) of b = d/(g – r)
(either both g and r in real terms or both in nominal terms). If r > g,
then a primary budget deficit would lead to a growing debt ratio. In a
similar vein, a continuing total budget deficit of d ′ (including interest
payments) leads to a debt-to-GDP ratio stabilizing at d ′/g, where here g,
the GDP growth rate, is in nominal terms. This implies that d + rb = gb,
or d = (g – r)b, and hence if g is less than r, the primary budget deficit is
negative (i.e., primary budget is in surplus). This analysis refers to the
long-term sustainable relationship between deficit and debt and uses the
average rate of growth, and is not a relationship that necessarily holds
in any particular year.
The case where g = r is of particular interest. Pasinetti remarks that
this case
represents the “golden rule” of capital accumulation. . . . In this case, the
public budget can be permanently in deficit and the public debt can thereby
increase indefinitely, but national income increases at the same rate (g) so
that the D/Y ratio remains constant. Another way of looking at this case
is to say that the government budget has a deficit which is wholly due to
interest payments. (1997, p. 163)

The “functional finance” approach to fiscal policy would entail two

points concerning the debt ratio. First, budget deficits arise because
of a lack of aggregate demand, and the deficits enable savings to take
place. If there were not a budget deficit, then S could not exceed I,
336 JOURNAL OF POST KEYNESIAN ECONOMICS

and the savings in excess of investment could not occur. Savings are
undertaken voluntarily, and the acquisition of financial assets is the
counterpart of savings. Thus, the debt is held voluntarily. Second, as
the relevant budget deficit is the overall one, then the debt-to-GDP ratio
would stabilize at d/g, where d is the deficit-to-GDP ratio and g is the
nominal growth rate.
The formulation in Equation (1) does not specify how frequently
adjustments should be made to tax and expenditure plans and hence to
the budget deficit. In Sawyer (2009), a distinction was drawn between
“coarse-tuning” and “fine-tuning” with regard to fiscal policy. In the
former, an equation such as (1) would be used based on the underlying
coefficients of the functions involved, and a “trend” budget deficit can
thereby be calculated. In effect, this forms the rule for fiscal policy. Fine-
tuning would then be the more short-term approach to fiscal policy. But
it is, of course, the case that fiscal policy, along with tax and expenditure
decisions, has to be set on an annual basis so that there is some form of
tuning. The question then arises as to whether more frequent adjustments
would be warranted, and the experience with the financial crises suggests
that there are at least occasions when within a year adjustments to the
fiscal stance are needed. A fiscal policy committee (FPC) analogous to
a monetary policy committee (MPC) has been suggested in a number of
forms (see, e.g., Arestis, 2009a; Wren‑Lewis, 2003). It is often objected
that the politically sensitive nature of tax and expenditure decisions
and the need for those to be taken by Parliament prevents this. Further,
while lowering taxes and raising transfers may be an acceptable way of
responding to a downturn, it is unlikely to be an acceptable way of dealing
with an upturn—“your benefit has been cut this week as the economy is
growing too fast” would not be well received. But there are taxes, such
as value-added tax and social security contributions, that could be varied
in this manner. Interest rates, which appear as a cost to many (though
income to others), are of course, already varied in this way. The role of an
FPC could then be to judge on, say, a six-month basis whether a change
in tax rates would be warranted. And, as Leith and Wren‑Lewis (2005)
comment on Wren‑Lewis’s (2003) suggestion:
Wren‑Lewis (2003) suggests giving a “fiscal stabilization authority” a
small number of fiscal instruments, chosen for their potency in influenc-
ing the macroeconomy. This authority would only be allowed to make
temporary changes in these instruments, and might even be given its own
budget which would have to be balanced within a specified time frame.
(Leith and Wren‑Lewis, 2005, pp. 595–596)
 The Return of Fiscal Policy  337

These types of proposals are viewed here as relating to the variation of

fiscal policy toward the fine-tuning end of the spectrum. The underlying
fiscal position, the composition and level of public expenditure, and the
structure of the tax system could be set as discussed under “coarse-tuning”
and through the existing democratic processes.

Assets and liabilities

It is a notable feature of most discussion on the capital account position
of the public sector that there is rarely mention of assets. The focus of
attention is on the level of public debt (often expressed relative to GDP).
There is little mention that the debt of the public sector is an asset for those
holding it. Further, there is little mention of the assets of the public sector.
Even when there are notions of a “golden rule,” such that the government
should only borrow to fund public investment, there is recognition of the
addition to public debt, which may be involved. However, there is very
little recognition that public investment adds to public-sector assets. The
argument here is that if any attention is to be paid to the level of public
debt, then it has to be undertaken in conjunction with an assessment of the
assets of the public sector alongside the liabilities. The simple argument
for considering the assets and liabilities of the public sector is simply
that no one would think of only considering the liabilities of a private
firm without any regard to their assets.
The measurement of the value of public-sector assets is fraught with
difficulties, though whether those difficulties are more significant than
the measurement of private-sector assets is debatable. The significance
of looking at assets and liabilities of the public sector arises in a number
of crucial ways.
One set of considerations is concerned with the notion of an intertem-
poral budget constraint. This relates to the idea that government faces
a budget constraint, and one that is similar to private households in that
the present value of expenditure is less than or equal to wealth, which
includes discounted future income. For government, this translates into
the notion that the limit of the discounted outstanding government debt
as time tends to infinity is zero. Then, the present values of taxes must
be equal to the present value of government spending plus the value of
the initial government debt given the “no Ponzi game” condition. An
alternative expression of this is that the government must choose a path
of spending and taxes such that the present value of the primary deficit
equals the negative of initial debt, so that “if the government has positive
338 JOURNAL OF POST KEYNESIAN ECONOMICS

outstanding debt, it must anticipate running primary surpluses at some

point in the future” (Blanchard and Fischer, 1989, p. 55). In Arestis and
Sawyer (2008b), we argued that the counterpart of the intertemporal
budget constraint for the public sector was a constraint for the private
sector of the form present value of future savings equal to present value
of future investment. This is in effect the dynamic equivalent of Say’s
law expressed in terms of the equality of desired investment and desired
savings.
The argument here though relates to the point made by Blanchard and
Fischer (1989), as quoted above, that because it can be readily observed
that government has outstanding debt, then it must run primary surpluses
in the future. When it is recognized that government owns assets, which
have a market value, then it would seem appropriate to cast any budget
constraint in terms of some equality between assets and liabilities, rather
than between liabilities and zero. Public-sector assets have a value: at a
minimum, an asset can be sold to the private sector and then leased back to
government. This, after all, is the notion that underlies the private finance
initiative and activities such as “shadow” toll roads. Because governments
hold substantial assets, then the intertemporal budget constraint would
no longer imply that government would necessarily need to run a future
surplus. The net asset position of governments is illustrated in Table 1.
Another set of considerations relates to the nationalization of parts
of the financial sector, which has been undertaken during the present
financial crisis. This clearly involves an increase in the assets of the
public sector as well as the debt. A focus on both assets and liabilities
of the public sector would have served to avoid the need to “bend rules”
(e.g., diverging from the previous 40 percent target for public debt in
the United Kingdom). Although in the circumstances of nationalization
as a rescue measure there are greater difficulties than usual in valuing
the firm to be acquired, bringing assets into the picture could have had
two side benefits. First, the government could have devoted more time
and effort to “due diligence” in deciding whether to acquire the firm (or
follow the alternative of allowing the company to go out of business).
Second, there would have to be attempts to consider what the costs of
such “bailouts” could be. They would, in effect, be the difference between
the cost of acquisition and the value of the company. The asset–liability
approach might have helped to limit the degree to which governments
have overpaid for “bailouts.”
Yet another set of considerations relate to the reporting of public–
private partnerships and private finance initiative, which is often akin
to off-balance–sheet activities. The systematic reporting of assets and
 The Return of Fiscal Policy  339

Table 1
Government net capital stock in 22 OECD countries (as a percentage of
GDP at 1995 prices)

Country 1980 1990 2000

Australia 53.8 46.5 40.0

Austria 75.4 69.3 57.0
Belgium 40.2 45.5 37.9
Canada 41.6 40.0 38.4
Denmark 76.4 60.8 45.9
Finland 43.7 47.1 46.9
France 55.0 53.0 54.0
Germany 58.4 52.0 47.1
Greece 44.4 51.9 51.0
Iceland 48.4 50.5 50.7
Ireland 75.9 66.8 35.2
Italy 44.7 49.0 47.9
Japan 97.7 95.7 117.1
Netherlands 80.2 68.9 56.4
New Zealand 110.3 102.4 76.6
Norway 49.3 52.5 50.5
Portugal 27.9 32.0 43.3
Spain 35.8 40.9 48.0
Sweden 42.1 40.2 42.0
Switzerland 46.1 48.4 54.7
United Kingdom 63.9 48.5 40.3
United States 59.9 54.1 50.0
Unweighted average 57.8 55.3 51.4
Source: Kamps (2006).

liabilities which would include future obligations under leasing arrange-

ments, which public private partnerships and private finance initiative
are, would lead away from the present practices with off-balance–sheet
activities and obligations for future payments not included as part of the
government debt.

Deficits and interest rates

The conventional argument is that budget deficits place upward pressure
on interest rates, leading to a crowding out of investment expenditure.
The “functional finance” approach advocates budget deficits when there
is inadequate demand and hence does not lead to any “crowding out.”
There is also the sense (see Equation (1)) that the budget deficit funds
itself, thereby ensuring that there is adequate funding without any upward
pressure on interest rates. But there are two situations in which a budget
deficit and associated public debt could place some upward pressure
340 JOURNAL OF POST KEYNESIAN ECONOMICS

on the interest rate on government bonds. This is, though, not a general
crowding argument in that it is not envisaged that there is a general pres-
sure on interest rates and that interest rates for private borrowers rise,
thereby reducing investment (indeed, the first argument points to perhaps
lower interest rates for private borrowers). First, the continuing budget
deficit means that government bonds are being sold, and the relative
composition of financial assets is changing. A higher (than otherwise)
budget deficit clearly means that government bonds as a proportion of
total financial assets is greater than it would have been, and this could
entail lower price/higher interest rate on government bonds. But the other
side of that is that nongovernment bonds carry a higher price/lower inter-
est rate. However, because there is a general balance between demand for
and supply of funds, this would not constitute general upward pressure
on interest rates. When considering the level of interest rates, the role of
the central bank also has to be brought into the picture.
Second, it is a general proposition in Keynesian economics that there
is strong sense in which investment “causes” savings rather than savings
“cause” investment. For the moment, consider the simple case where there
is no government and no foreign sector. The accounting identity ensures
that ex post savings S * = ex post investment I *, and let us suppose that
in a given period that also corresponds to ex ante savings S + = ex ante
investment I +. Now conduct the thought experiment of increase in inten-
tions to invest. If those intentions are carried through, then in the relevant
period S * = I *, and after some adjustments S + = I +, and in that sense
corresponding savings will become available. But at the time when there
is the intention to invest, those savings do not exist. The realization of
the investment intentions requires availability of finance, and the usual
route postulated is by bank lending. Banks in this context have the abil-
ity to create loans and thereby create money and purchasing power. The
effect that increased investment intentions has on interest rates depends
on the reactions of banks. If, as is often assumed, banks readily supply
loans at the going loan interest rate, then there would be no immediate
pressure on interest rates.
Now introduce government into the picture. It is rather paradoxical that
while private firms have access to loans, which thereby change the money
supply, government (here taken to exclude the central bank) is not able to
“print money” to finance its spending. If there is a relationship between
budget deficit, sale of bonds, and the money supply, then it comes through
the endogeneity of money at the interface of banks and the central bank.
That is, the central bank (in normal times) provides reserves to the bank-
ing system in exchange for government bonds, and it is only at the point
 The Return of Fiscal Policy  341

where government bonds are exchanged in this way for reserves that the
government deficit could be said to be money financed or monetized. The
immediate effect of a larger government budget deficit is that the govern-
ment has to borrow for what is at that point in time a pool of savings. If
the government deficit is increased, then a higher (than otherwise) level
of income will result, and subsequently higher tax revenues and higher
savings.9 It could then be anticipated that there will be occasions when
a government finds some difficulty in securing funds, particularly if its
“offering” is not as attractive as it might be.
Any expansion of demand starting from a position of low economic
activity faces the issue that the expenditure has to be financed, and that
the raising of finance may place some upward pressure on relevant rates
of interest. There is little that is unique about an expansion of public
expenditure rather than private expenditure in that respect. But any pres-
sure is limited, and when the expansion has taken place, corresponding
funds are generated.

Budget deficits and the balance of payments

It is often argued that using fiscal policy, and particularly running a budget
deficit, has consequences for and is constrained by balance-of-payments
considerations. Equation (1) can be used to highlight some of the issues.
Insofar as private domestic savings and investment are closely related,
then the equation suggests a link between two deficits (the “twin deficit”
issue) with a link between budget deficit and current account deficit.
It should first be noted that, in general, current account deficits pose a
much greater constraint on an economy than budget deficits. Both require
borrowing and the incurring of future debts and interest (or equivalent)
payments. But whereas the public debt is a liability as far as the govern-
ment and taxpayers are concerned, it is an asset as far as the bondholders
are concerned. The interest payments on bonds are a domestic transfer
between taxpayers and bondholders (to the extent that bonds are held
domestically). The relevant rate of interest on bonds for sustainability
of deficits is the posttax rate of interest. We have argued elsewhere (see,
e.g., Arestis and Sawyer, 2006b) that empirically the posttax real rate

9 Often, as in the present, larger budget deficits arise from a slowdown in the econ-

omy, which results in lower tax receipts. The government is then faced with the choice
of increased borrowing or attempting to raise taxes or reduce expenditure. The point
here is that without the increased budget deficit and borrowing, the level of economic
activity would continue to decline, and the budget deficit is acting as an “automatic
stabilizer.”
342 JOURNAL OF POST KEYNESIAN ECONOMICS

of interest on government bonds is around the rate of growth. Indeed,

it can also be noted that according to Taylor, in the formulation of what
came to be labeled Taylor’s rule, it is that “the 2‑percent ‘equilibrium’
real rate is close to the assumed steady-state growth rate of 2.2 percent”
(1993, p. 202). Further, as noted above, when it is the overall budget
deficit, including interest payments, that is the focus of attention and
that is relevant for “purposeful” fiscal policy, then the outstanding public
debt will stabilize at d ′/g.
It can further be argued that what is relevant for fiscal policy and
stimulus is the overall budget deficit, whereas for current account it is
the trade deficit that is generated from private decisions and relates to
production and consumption decisions.
Insofar as government debt is denominated in the domestic currency,
the government is always in a position to avoid default on the debt,
whether that comes from its tax raising powers or in extremis ability via
the central bank to create the necessary money. We may rewrite Equa-
tion (1) to make the point:
G ′ + iB – T = S(YT) – I(YT) + M(YT, e) + rOD – X(e), (2)
where the symbols are as above, with the following additions: G ′ is
government expenditure excluding interest payments, B is outstanding
bonds, i is the posttax rate of interest on bonds, OD is net overseas debt,
r is the rate of interest on overseas debt, and e is the exchange rate. There
is one important point to clear with the help of Equation (2). It is argued
by the proponents that if the debt gets large enough, all the government
income will go toward interest and there will not be anything left for
other spending. It is clear that government spending is not operationally
revenue constrained. Government can spend whatever it wants regardless
of whether it is in surplus or deficit. And, of course, the government sets
the interest rate it pays on its debt, not the market. In this context, it is
interesting to note that Japan paid near zero rate of interest for a decade
with a debt of 150 percent of GDP, annual deficits of 7 percent of GDP,
and a very low credit rating; the ability of the Japanese government to
make the necessary payments was never the slightest issue.
Insofar as Equation (1) is concerned, if it cannot be satisfied because
the resulting current account deficit and the corresponding financial ac-
count surplus cannot be achieved, then this should not be seen as an issue,
particularly for fiscal policy, but rather that the country concerned faces a
balance-of-payments problem. In effect, any policy that sought to achieve
income of YT, would run into essentially the same problems (see caveat
below). For example, if monetary policy were the instrument of choice
 The Return of Fiscal Policy  343

to achieve the desired level of income, a current account deficit would

still result. Further, even if there was a strong belief in market forces that
would restore income and output to a market clearing “full employment”
position, there would still be a current account deficit.
The current account problems in the case of the use of fiscal policy
as compared with other policies may differ in three respects. First, the
target level of income may be different. If fiscal policy were used in a
more ambitious way, then the target level of income would be greater and
the corresponding current account deficit larger to satisfy the identity.
Second, the composition of demand would differ between the different
“solutions,” and hence the demand for imports would differ. It could be
argued that fiscal policy insofar as it utilized expansion of government
expenditure in a directed fashion could have a lower import content
than a corresponding expansion of private demand through interest rate
reductions. Third, different policy regimes have effects on the exchange
rate. For example, a lower interest rate designed to stimulate the do-
mestic economy could well lead to a lower exchange rate, which would
(provided the Marshall–Lerner conditions held) ease the current account
deficit problem.10
It could be argued that issues over the current account deficit could be
removed through appropriate changes in the exchange rate (in general,
subject to Marshall–Lerner conditions holding). It is possible that the nec-
essary change in the exchange rate would lead to intolerable reductions in
terms of trade and living standards. But the major difficulty relates to the
vagaries of the exchange markets. For this reason, we believe intervention
in the foreign exchange market by the central bank is important.
The thrust of the argument in this section is that there may be balance-
of-payments constraints on the use of fiscal policy to achieve a high
level of demand and income. However, those constraints should not be
viewed as specific to fiscal policy but rather constraints on the economy
achieving through whatever means a high level of income and output. The
constraint in the open economy case may be particularly serious in the
case of developing economies, where public debt is often denominated in
a foreign currency rather than a domestic currency. However, and as just
argued, the foreign borrowing aspects should be seen as a general con-
straint not specifically on fiscal policy. It is also the case, and in a similar
vein, that private debt may also be denominated in foreign currency. The
10 Two further caveats are as follows: interest rate parity suggests that a lower do-

mestic interest rate would be associated with a rising exchange rate; if “sentiment” in
the exchange markets responds favorably to the prospect of higher domestic income,
then the exchange rate would tend to appreciate.
344 JOURNAL OF POST KEYNESIAN ECONOMICS

policy conclusion (easily stated but only resolved with great difficulty)
is to direct policy toward relieving the balance-of-payments constraints
rather than foregoing the use of fiscal policy.
Fiscal policy can itself only address issues of demand deficiency
(or excess) aggregate demand, though the composition of government
expenditure and the structure of taxation can address other issues (e.g.,
the role of public investment in terms of growth, taxation with respect
to income distribution). The effective use of fiscal policy can often be
constrained through (as discussed here) balance-of-payments constraints
and through a lack of productive capacity (which we have not addressed
here but which may prevent the achievement of high levels of employ-
ment through lack of capacity and hence also the achievement of desired
levels of output). But those constraints should be viewed as operating on
any policy options (including the “do nothing” policy) and not specific
to fiscal policy, and that the appropriate response is the development of
policy instruments, which directly address those constraints.

Concluding remarks
It is evident that the use of fiscal policy has been one of the major policy
instruments used in many countries to offset some of the devastation
wrought by the financial crisis. Its use has seen budget deficits in many
countries rise to high levels (when judged against previous experience)
and the prospects of debt-to-GDP ratios rising for a number of years to
come. This return of fiscal policy must be welcomed. The major chal-
lenge for fiscal policy in the years ahead is to establish the principles of
“functional finance” and the probable need for long-term budget deficits
in many countries. By reference to Equation (1), it can be readily seen
that budget deficits can only be reduced through some combination of
higher investment, lower savings, higher exports, and lower imports. The
danger is that with the prospects that firms will be reluctant to invest and
households spending less and saving more, the attempt will in effect be
made to reduce budget deficits through old-style deflation, cuts in public
expenditure, and increased tax rates.
The alternative, which must be pursued, is that unless and until invest-
ment strongly revives and households are able to spend without incur-
ring high debt levels, budget deficits will have to continue. It ought to
be noted also that in all this it should be remembered that the revival
of the banking-sector lending activity is also paramount. Tackling the
problem of the current frozen banking systems is also important and is
paramount.
 The Return of Fiscal Policy  345

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