Fiscal policy and the economy – The case for more spending

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“If the Treasury were to fill old bottles with bank-notes, bury them at suitable depths in disused coal-mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of repercussions, the real income of the community, and its capital wealth, would probably become a good deal greater than it actually is.” (J.M. Keynes, the General Theory)

In his “General Theory”, the great economist J.M. Keynes argued that recessions are mostly driven by a fall in the aggregate demand for goods and services. This entails that they can be cured rather easily, provided that the Government steps in at the right time to compensate the fall in private expenditures.

The main argument is straightforward: by investing more, by employing more people, and by purchasing more goods and services from the private sector, the government actively sustains incomes and, thus, boosts aggregate demand. In turn, this stimulates employment and investments in the private sector. As a result, GDP increases and people are better off.

The additional debt that must be issued to finance deficit spending is not a problem, since future growth will make it easier to collect sufficient amounts of taxes for its repayment. Moreover, the obvious argument that a debt crisis cannot be healed with more debt is contradicted by the fact that highly indebted countries like the USA or Japan are currently paying negative real rates on their debt.

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In conclusion, countercyclical government spending might be successfully employed for sustaining the economy in bad times.

The reasoning presented thus far seems to be very clear and, in a sense, sounds just “right”. This notwithstanding, there are some evident pitfalls that should be outlined and discussed.

To begin with, households might actually be worried about their income prospects throughout all their lives. When the government increases spending by taking on more debt, it undertakes a long-term obligation to raise additional taxes to pay it down. Therefore, rational agents will save more in the face of a surge in government expenditures. Notice that the same works when a tax cut is implemented without cutting expenditures to the same extent. Reducing taxes in the short run implies that the government needs more taxes in the future: again, rational agents would probably save the extra money they receive (this is the famous concept of Ricardian Equivalence).

Second, the Keynesian argument for public expenditures does not take into account the welfare effects of such a policy. Indeed, goods and services purchased by the government will not necessarily benefit all households alike, while the additional taxes will affect all of them.

To clarify this point with an example, consider the quote at the beginning of the article: even if it was true that spending increased the wealth of this “digger’s society”, the wealth in itself would in part be wasted in digging the holes, filling them, and digging them again just for the sake of obtaining the money inside the bottles: the digging activity does hardly benefit anyone. Part of the wealth that is thus created through the intervention of the State does not increase the welfare of people. The same is true to some extent when we consider realistic projects that a government might undertake: high speed trains, world fairs, Olympic games, and so on. These projects are extremely costly and usually benefit a small share of the population.

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With this in mind, we turn to the other side of the debate, which argues that a smaller presence of the government is needed for the economy to prosper.

Michele Fornino

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Articles written by the various members of our team.

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