Fiscal policy and the economy – The case for less spending

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“The government solution to a problem is usually as bad as the problem.” (M. Friedman)

The main arguments put forth by the “fiscal hawks” stem both from abstract principles of classical economics, and the observation of the current debt crisis that is battering the most profligate countries in the Eurozone.

Classical principles of economics hold that wealth is created through the efforts of individuals that compete with each other in the markets for goods, labor and capital. The continuous contrast between agents is what spurs them in increasing their productivity, thus producing higher and higher levels of wealth.

It is often argued that public intervention interacts with the proper functioning of markets, thus leading to inefficiencies: only when the standard assumptions of competitive markets are violated, is the government “allowed” to intervene to restore a better outcome. In more specific terms, an increase in public expenditures is deemed ineffective in restoring wealth creation for a number of reasons. We will outline some of them.

In standard classical frameworks, public expenditures on goods and services hinder private consumption and investments, because the taxes required for their funding entail a reduction of the lifetime income of individuals. The tax system itself, moreover, is often designed according to equity considerations that usually contrast with economic efficiency: under certain circumstances, for instance, lump sum taxation is efficient, but it is also regressive and seldom compatible with a basic sense of fairness and equity.

Productive activities directly operated by the public sector are deemed inefficient as well: indeed, the collective mechanism of choice through which public enterprises are created is often distorted by considerations other than pure market signals. This objection acquires additional strength if we consider that many states in southern Europe are used to financing public enterprises even when production is not economically sustainable.

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Public funds, moreover, have an opportunity cost that is the interest rate on public debt: the state should only undertake those investments for which the expected return is higher than the yield on government bonds. The return on public investment is seldom as high as the yield on government bonds.

In many cases, public debt is high enough to threaten even the confidence of financial markets in the solvency of the governments. In turn, this leads to higher yields and to the impossibility of rolling over the pre-existent debt without either cutting abruptly the expenditures or raising additional taxes.

Despite being tightly grounded into economic reasoning and theory, these objections overlook two main facts: the short-term effects of a reduction in government expenditures are mainly recessionary, and the underlying hypotheses are seldom verified in the actual economic environment.

On the one hand, public expenditures are included in national accounts and are part of the national income identity: whenever a fiscal consolidation is undertaken, the GDP will be lower for a sheer matter of accounting. The supposedly positive effects on consumption and investments will typically be realized after some periods. The Greek fiscal consolidation epitomizes this fact: a stark reduction in public expenditures, coupled with an ongoing credit crunch, has crippled the Greek economy since 2010, thus making it virtually impossible for that country to reduce its humongous debt.

On the other hand, some hypotheses that are crucial in macroeconomic models – among these, the responsiveness of prices, the existence of perfect financial markets, and the absence of distortions in labor markets – are all but realistic. When these assumptions are removed, the consequences of an increase or of a reduction of public expenditures are admittedly different: it is actually possible to counteract a recession by using fiscal policy in a countercyclical way.

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After having outlined some of the main lines of reasoning in the two sides of the debate, we will review the evidence that economists have been able to gather and interpret.

Michele Fornino

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