June 08, 2012 | Filed Under » Business, Economics, Economy, Financial Theory

A basic teaching of macroeconomic policy holds that governments should run deficits when the economy is in a recession. By influencing tax rates, interest rates and the rate of government spending, there should always be monetary and fiscal levers that the federal government and Federal Reserve can pull to help pull an economy out of its funk. Based on the above theories, politicians appear to have their solutions to ensuring an economic recovery mixed up. One side is looking to raise taxes, while the other is trying to push through austerity measures to cut government spending and reduce deficits that now run into the trillions of dollars.

Finances Need to Be in Order
Of course, governments cannot spend more than they take in indefinitely. A recent chart published by the Economist periodical detailed that most governments have run deficits for around 30 years now, meaning that it has been a generation now where governments have relied on loans to fund the gap between revenues and expenses. This problem appears to now be coming to a head in Europe, and many are worried that the U.S. could eventually face severe problems if the central government doesn’t get its finances in order. 

Austerity measures in the U.S. could work, and they will be the only choice if the government can’t find ways to raise its revenues. One study detailed that the government cut back on spending significantly following the end of World War II, and this did little to hold back the private sector from one of its more successful expansion periods in the history of the U.S.

Of course, spending by businesses and individuals would have to come in and offset any cuts in government spending to keep the economy moving forward. Budget deficits serve as an economic stimulus by pumping spending into businesses and other entities. There is even the concept of the crowding out effect where the government becomes too large and effectively crowds out private company lending and other business activities. If this is the case, then austerity could end up helping improve the economy and put it on more solid footing.

Spend More, Despite the Economic Climate
The trend since the 1980s has been for the government to spend more than it earns regardless of the economic climate. Returning to theory, governments should be stockpiling taxes and other revenues when the economy is on an upswing and saving it for a rainy day to help get the economy back on its feet during a downturn. Unfortunately, entitlement programs and the steady growth of government organizations has continued unabated for many years.

One way or the other, the government will eventually have to live within its means. Ideally, it will be able to find a way to spur the economy, which would bring in higher tax revenues. The reality is that a combination of growth and cost cutting, especially in the areas of social security and healthcare expenditure, will be needed to bring the deficit back to more reasonable levels.

The Bottom Line
It makes sense that the government should hold back on any major austerity measures until the economy is solidly on its next upswing. Otherwise, it risks sending the economy back into recession. The risk is that the economy continues to struggle and that austerity measures will become inevitable. But with any planning and common sense, the government should be able to avoid a worst-case outcome.