Discretionary Fiscal Policy

Discretionary fiscal policy is the deliberate action taken by a government to influence the economy by changing its spending levels or tax rates. Think of it as the government actively turning the knobs of its financial machine, as opposed to letting the system run on autopilot. This is the counterpart to automatic stabilizers, which are policies like unemployment benefits that kick in automatically without new legislation when economic conditions change. In essence, while automatic stabilizers are the economy's built-in shock absorbers, discretionary fiscal policy is the government grabbing the steering wheel to navigate through rough patches like a recession or to cool down an overheating economy. These actions are decided upon by policymakers—politicians and government officials—in response to specific economic events. For example, during a downturn, the government might pass a new bill to fund large infrastructure projects or cut taxes to encourage spending and investment. Conversely, if inflation is getting out of control, it might raise taxes or cut spending to slow things down. It's a hands-on approach to economic management, distinct from the actions of a central bank, which uses monetary policy to achieve similar goals.

The government has two primary tools it can use to implement discretionary fiscal policy. Both are designed to influence the total level of spending in the economy, also known as aggregate demand.

This is the most direct tool. The government can simply choose to spend more or less money.

• To stimulate the economy, it can increase spending on things like:
  1. Public works projects (roads, bridges, green energy).
  2. Direct aid to households (stimulus checks).
  3. Increased funding for public services like healthcare or education.
• To cool down the economy, it can cut spending in these same areas.

This direct injection (or removal) of cash into the economy can have a powerful, immediate impact, creating jobs and boosting demand for goods and services.

The second tool is adjusting taxes. By changing how much it collects from households and businesses, the government can influence their spending and investment decisions.

• To stimulate the economy, it can:
  1. Cut income taxes, leaving more money in consumers' pockets to spend.
  2. Cut corporate taxes, encouraging businesses to invest and hire.
  3. Introduce tax credits for specific activities, like buying an electric vehicle or investing in new machinery.
• To cool down the economy, it can raise taxes, which reduces disposable income and profits, thereby dampening spending.

Tax changes can be powerful, but their effect is often less direct than government spending, as it relies on people and businesses choosing to spend or invest their extra cash.

Discretionary fiscal policy is typically categorized by its goal: to speed the economy up or to slow it down.

This is the go-to strategy during a recession or a period of slow growth. By cutting taxes or increasing government spending, policymakers aim to increase aggregate demand. The goal is to create a virtuous cycle: more government spending leads to more jobs and income, which leads to more consumer spending, which encourages businesses to produce more and hire more workers. The famous American Recovery and Reinvestment Act of 2009 in the U.S. and various COVID-19 relief packages across Europe and America are prime examples of expansionary policy.

This is used less frequently but is a crucial tool for fighting high inflation. When the economy is growing too fast, demand for goods and services can outstrip supply, pushing prices up. To combat this, the government can raise taxes or cut spending. This reduces overall demand in the economy, easing the pressure on prices. It's often politically unpopular—no one likes higher taxes or cuts to public services—which is one reason why central banks are usually the first line of defense against inflation.

For a value investing practitioner, who focuses on the long-term health and intrinsic value of businesses, discretionary fiscal policy is part of the macroeconomic backdrop. It's not something to trade on, but it is something to understand.

Well-executed expansionary policy can shorten recessions and prevent economic disasters. By cushioning a severe downturn, the government can help viable businesses survive, prevent mass unemployment, and maintain a stable social fabric. This protects the long-term earning power of the companies in an investor's portfolio. A stable economy is the best environment for long-term compounding.

The real world is messy, and fiscal policy is notoriously difficult to get right.

• Lags: There's a recognition lag (it takes time to realize there's a problem), an implementation lag (the political process of passing new laws is slow), and an impact lag (it takes time for the policy to affect the economy). By the time a stimulus package hits, the economy might already be recovering, leading to overheating.
• Politics: Fiscal policy is made by politicians, not economists. Decisions can be driven by election cycles and political favors rather than sound economic principles.
• Debt: Expansionary policy, especially tax cuts and spending hikes, almost always increases the national debt. While manageable debt is fine, a constantly growing debt burden can lead to higher interest rates and future tax hikes, creating a drag on long-term economic growth.

Two major risks can undermine the intended benefits of fiscal stimulus.

1. Crowding Out: When the government borrows massive amounts of money to fund its spending, it competes with private businesses for a limited pool of savings. This can drive up interest rates, making it more expensive for companies to borrow and invest in new projects. In this scenario, government spending “crowds out” private investment, potentially leading to no net gain for the economy.
2. Inflation: If the government pumps too much money into an economy that is already near its full capacity, the result is almost always inflation. Too much money chasing too few goods leads to higher prices, which erodes the purchasing power of consumers and the real value of corporate profits. This is a nightmare for investors, as it distorts financial statements and devalues long-term cash flows.

• Be an informed observer, not a speculator. Understand the direction of fiscal policy and its potential impact on inflation and interest rates.
• Don't try to time the market based on anticipated government actions. The lags and political nature of fiscal policy make it highly unpredictable.
• Focus on business fundamentals. A company with a strong balance sheet, a durable competitive advantage, and pricing power is best equipped to thrive regardless of the government's fiscal tinkering.
• Always invest with a margin of safety. Fiscal policy can create unforeseen economic turbulence. A margin of safety in your valuations provides a buffer against both economic downturns and the unintended consequences of government intervention.