♪ [music] ♪ - [Alex] Most economists agree
that fiscal policy is useful when many resources
are underemployed due to an aggregate demand shock, and the economy needs
a short-run boost. There's less agreement
when it comes to using fiscal policy to combat shifts
in aggregate supply, and less agreement
over the potential dangers of debt-financed fiscal policy. Let's consider. Instead of a shift
in aggregate demand, suppose the economy suffers
a real shock, a shift in the aggregate
supply curve. The economy moves
from point A to point B and falls into a recession. Fiscal policy in this situation --
it's relatively powerless. A big increase in aggregate demand
could increase real growth somewhat but mostly at the cost
of much higher inflation. When real growth slows
due to an aggregate demand shock, the economy is operating
below its potential so there's more room
for fiscal policy to bring the economy
back to potential. But when real growth slows due
to an aggregate supply shock, it's the potential growth rate
that has fallen. There's less inefficiency
in the economy, and thus fiscal policy
has less power. Keep in mind as well that all the earlier problems
of fiscal policy -- timeliness, targeting,
and crowding out -- they also apply to fiscal policy when combatting
an aggregate supply shock. It's just that this time, more spending has
the additional challenge that it can't really solve
the underlying problem. The economy
has fundamentally changed, and attempting to fix it leads
mostly to higher inflation rates. Fiscal policy can also be
a dangerous tool when used too much. In theory, fiscal policy is like
national consumption smoothing: increase aggregate demand
in bad times, and pay off the bill in good times. But in practice, politicians usually
only follow half of this advice. They spend in bad times,
because they have to -- and they spend in good times
because they can. Like many of us, politicians find it easier
to add to the credit card bill than to pay down the debt. We're just not that great
at national saving. And if a government's debt
continues to grow, it'll end up spending a larger
and larger portion of its budget on interest payments alone, making it more difficult to act
in a future recession. In other words, if we repeatedly
used debt-financed fiscal policy to stimulate the economy
again and again, and we never pay down that debt, then we'll eventually
back ourselves into a corner with no ammunition, just when we need it most. Is it possible
to have too much debt? Certainly. And here's where
it gets really dangerous. Too much debt, especially when a country
borrows money from another country in the other country's currency -- this can create
uncertainty, and risk, and even lead to economic collapse. Take, for example, Argentina's
financial crisis of 1999 to 2002. In the years
leading up to the crisis, Argentina's government
was spending and borrowing more and more and more, making investors and citizens
a little nervous of its ability
to pay off its debts. So when the economy
suffered a financial crisis, and the government tried
to spend even more to stimulate the economy,
to get out of the crisis, citizens and investors
took that as a bad sign rather than as a good one. In fact, citizens and investors
drastically reduced their spending and investing -- so much so that the country
experienced declines in real GDP rather than growth. In other words,
consumption and investment fell by more than government
spending increased -- over 100% crowding out! By 2002, Argentina's debt
was 150% of GDP, and the government
defaulted on its payments. This was the largest
government default in the history of the world. But other developing countries --
Thailand, Indonesia, and Mexico, and even Greece -- they've experienced
similar scenarios. So how much debt is too much? Well, there's plenty of room
for debate on this, but it's clear that
if a government's credibility is low and its debt is high, then fiscal policy can have
an immediate negative effect, at least in some
economic situations. Fiscal policy is a useful tool, but to be used well,
it must be used wisely. - [Narrator] You're on your way
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by taking a few practice questions. Or, if you're ready
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