A Balanced-Budget Constraint in Modern Stochastic Macromodels

Abstract

Currently (September 1985), a constitutional balanced-budget amendment is pending in the U.S. Senate. Thirty-two states have passed resolutions calling for a constitutional convention to enact such an amendment. In 1963 Senator Harry Byrd, Sr. asked Budget Director Kermit Gordon what balancing the budget would do for the country. Gordon replied that, probably would add about 2.5 million people to the rolls of the unemployed, delay the recovery about four years, and knock 10 percent off U.S. output [16, 284]. The Keynesian conventional wisdom of the 1960s was that fiscal and monetary policy should focus on the benefit-cost tradeoffs between inflation and unemployment (stabilization), along with tradeoffs implicit in resource allocation and the distribution of income. Given these objectives, there should be no independent consideration of the budget deficit of the federal government [24]. As Abba Lerner argued in his early statement of Keynesian principles of functional finance, the instruments to prevent unemployment and inflation are available until it is recognized that the size of the national debt is relatively unimportant [17, 302]. As outlined by Walter Heller [15] and others, the stabilization role of fiscal policy, together with monetary policy, in the 1960s was to provide the appropriate degree of stimulus or restraint to achieve a target level of real output. Since the mid-1960s such a role for fiscal policy has been challenged, first by the Friedman-Phelps [14; 27] accelerationist hypothesis and then by the Lucas-Sargent [19; 29] policy ineffectiveness proposition. The accelerationist or natural rate theory, especially as advanced by Milton Friedman, argues that stabilization policy should be geared toward rules and control of nominal variables such as the inflation rate. Friedman's analysis also implies the futility of using aggregate demand policy to achieve fixed output targets. Friedman's analysis suggests the possibility that with monetary policy geared to price stabilization and with sustainable real output gains not attainable via aggregate demand policy, fiscal policy instruments may be adjusted to achieve a balanced-budget without cost. Buchanan and Wagner [7] rely on Friedman's analysis to support their call for a constitutional balanced budget amendment.'