Question

Analyze the role of fiscal policy that was used during the great recession of 2008.

Answer 1

In response to the financial crisis in late 2008 and the subsequent recession, the United States has been running atypically high and persistent budget deficits. The recent behavior of key fiscal policy variables draws some parallels with the U.S. experience in the Civil War and the two world wars.1 The similarities and differences of these episodes shed some light on the current situation. A specific concern is the possibility of high inflation to finance the accumulated debt.

According to the latest estimates from the Office of Management and Budget (OMB), the primary deficit—outlays net of interest payments minus revenue—averaged 8.6 percent of gross domestic product (GDP) between fiscal years (FYs) 2009 and 2011.2 As a point of reference, this figure averaged roughly zero from 1955 to 2008. The top-left panel of the accompanying chart shows that the magnitude of the recent deficits is similar to those during the Civil War when the average deficit was about 8.5 percent of GDP. The two world wars are the only times in U.S. history with higher primary deficit levels. Even during the implementation of the New Deal policies (1933-36) in response to the Great Depression, the deficit averaged only about 3.7 percent of GDP.

A natural consequence of high deficits is a significant increase in government debt. At the end of FY 2011, debt held by the public—net of holdings in Federal Reserve Banks—was estimated at about 56 percent of GDP.3 Only during World War II and the years immediately thereafter was the debt-to-GDP ratio higher. So far, the increase in the debt-to-GDP ratio relative to the pre-crisis period—roughly 25 percentage points—is comparable to the rise during the Civil War, World War I, and the Great Depression