Saturday, November 26, 2011

The nature of deficit spending

As most of Europe struggle to refinance their now debilitating government debts, it warrants a careful examination of how “they”—by “they”, I mean all of us in the Western World, got into this mess.  The answer is surprisingly simple; it requires no conspiracy theory on evil too-big-to-fail Wall Street banks taking on too much risk or a Marx-like claim that capitalism and its “greed is good” mantra would ultimately lead to a system-wide failure.  Plain and simple, the Western governments, sanctioned by their voters, have spent too much too unproductively, for too long.

The real question is “how did our political process allow inefficient and excessive government spending to persist for so long?”  Are political parties and voters so unsophisticated in their comprehension of economics as to fail to grasp the problem of chronic deficit?  Let us take a step back and study a particular dimension of government expenditure.

Government stimulus program
The extensive economic literature exploring the effects of stimulus programs provides strong evidence that short-term growth, financed by deficit spending, rarely translates into sustained long-term growth.  The argument is that government-directed investments are often zero or even negative net present value (NPV) projects—that is, they tend to be suboptimal investments and often sub-optimally executed.  [Think central planning.]  Generally, if a project is truly of high economic value, private enterprises would likely have undertaken it.  Furthermore, bureaucrats, operating within the confine of complex politics, are usually not trained or incentivized to manage businesses effectively.   

From that perspective, government stimulus programs are, more often than not, about creating make-work jobs.  In this context, government stimulus is less about driving future growth but more about buttressing current consumption. To be sure, any government stimulus program, no matter how inefficient, will generate short-term increase in economic activity.  The problem is that the short term activity does not translate into future increases in production of valuable goods and services.

In a true Keynesian sense, government recessionary expenditure purely buffers temporary economic slowdown; it cannot substitute for private sector investments, which are necessary to drive long-term growth. Insofar that the government stimulus is financed by more debt, it necessarily translates into higher future tax burdens, which then drains future household consumption and investments.  Stimulus is thus a pure wealth transfer from the future to the present.

Is the government borrowing to “spend” or “invest”?
Under standard economic theory, the government either borrows temporarily to invest for future growth, and therefore drive future tax revenue, or it borrows to shift future consumption to the present in an attempt to ameliorate shocks to the economy.  In reality, deficits have mostly been chronic instead of temporary; it has a tendency to create ever-increasing debt.

We have been all too willing to believe the story that future growth driven by technological advances will deliver us from our debt problem.  Instead of investing for the future, we are often pre-spending future income.  We have been all too willing to believe that the problems we punt forward are easily solved by the future generation—so these problems are no problems at all!  Unfortunately, we may have just now hit a wall: The debt-to-GDP ratios for many developed countries have become untenable; additional borrowing capacity is small. There is no more kicking the can down the road for many countries.

The Boomer dynamics
The Boomers around the world have written into law rich benefits for themselves, which have to be financed by tax dollars from future generations. Adding insult to injury, they have also pre-spent future tax revenues through massive deficit spending today, which has resulted in hefty government debt. The combined weight of the explicit debt and implicit government-guaranteed obligations (such as state pensions and healthcare benefits) has begun to stress most of the developed economies and is already crushing some in the recent debt crisis.  Deleveraging, which has been proposed as the only responsible course of action for the developed countries, have not occurred in any meaningful way.  The calls for fiscal austerity as well as reduction in government welfare and benefits have been met with fierce resistance.

The policy of persistent deficit spending seems utterly irrational and short-sighted. However, one might argue that this outcome is exactly rational in the context of baby boom demographics prevalent in the developed countries.  Deficit spending gives an instant and immediate boost to GDP, which can feel like prosperity and good government stewardship. The natural conflict between the future retirees and future taxpayers means that Boomers, who have controlled the elections and politics, have rationally chosen a path of more consumption today at the expense of more taxes for the future generations. Whether deficit spending truly has any significant impact on subsequent growth is rather irrelevant to the discussion; voters and politicians alike would happily misinterpret the economic literature and assume more consumption today will drive more growth tomorrow.  In other words, and as scientific as one can put it—the Boomers have screwed Generation X.

Democracy not capitalism (politics not economics) is accountable
Perhaps I might be so bold as to suggest that “Democracy” instead of “Capitalism” is the contributing factor for our debt crisis.  It is not the failure of our chosen economic system for giving us access to debt financing; it is the failure of our chosen political system for favoring deficit spending instead of saving and investing.

Democracy is one of the great equalizers for income inequality in the cross-section of population. The poor have a mechanism to instigate wealth transfers by voting for welfare and public goods production.  Democracy seems to serve quite the opposite role, however, when it comes to equalizing the inequality between generational cohorts. There is no doubt that our future generations have become extremely poor; they are each responsible for tens of thousands of dollars in national debt, none of which were incurred by them.  But today, our political process continues to allow the Boomers to pile on new debt for the next generation, in order to fund their current consumption and future retirement.  It is the economic system, which is seeking to prevent the further floating of government debt.

In closing, let me leave you with two quotes, which seem so prescient now.

Lord Woodhouselee  (Alexander Fraser Tytler)
“Democracy cannot exist as a permanent form of government. It can only exist until the voters discover they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits from the public treasury…”

Sir Winston Churchill
“It has been said that democracy is the worst form of government except all the others that have been tried. “

by jason c hsu


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