Historically, deficit spending was a matter of debate among economists. Before the 1930s, it was widely agreed that governments should maintain a balanced budget and refrain from intervening during recessions. Until John Maynard Keynes put forward his theory of Keynesian economics, it was considered abnormal for a government to step in during a recession to increase aggregate demand. It was this revolutionary idea that provided governments around the world with the tools to intervene during recessions. It also provided the basis for many of the modern welfare states we see around the world. Time Magazine proclaimed that, “his radical idea that governments should spend money they don’t have, may have saved capitalism.”
The early 2000s saw once again the emergence of high deficit spending due to a combination of tax cuts, wars, and a recession. However, something strange happened, the fabled economic apocalypse never arrived; interest rates remained low and inflation stable.
“Left-wing” economists were overjoyed. At last, here was the proof that deficit hawks simply predicted doomsday scenarios which never arrived. It appeared that the early 2000s were proof that governments could spend without consequence. Out of the recession emerged a strange marriage between establishment economists. Both demand-side and supply-side economists collectively agreed that deficits no longer mattered, albeit for different reasons.
Supply siders now claim that the sluggish growth we are currently experiencing worldwide is essentially a supply-side issue. They contend that the economy is lacking the capital needed for healthy growth. In order to address this, they believe, the government should either cut taxes on business investment or invest in infrastructure projects. They believe that government is essentially an intermediary, borrowing from a pool of risk-averse savers to fund investments in the economy which will help long-term productivity.
Those who subscribe to MMT (Modern Monetary Theory) see the early 2000s as a success for their philosophy. They contend that since interest rates are controlled by central banks, the only side effect of deficit spending that governments should worry about is inflation. The governments of the UK, the US, and Japan should never worry about defaulting because they control their own money supply. Therefore, the only real worry (inflation) can be controlled through the collection of taxes to reduce the spending capacity of the private sector.
This growing consensus has excited certain sectors of the economics community who hail the return of large-scale deficit spending.
Although Regan and Thatcher claimed to rein in spending, they never actually did. Regan tripled the national debt and reversed the post-World-War II trend of a shrinking deficit. In fact, research from the Federal Reserve Economic Dataset shows that US debt as a percentage of GDP has risen steadily since the 1970s (see figure 1). The steady increase we can see in figure 1 shows us that government spending is no longer exclusively tied to downturns but also booms.
Figure 1. US debt to GDP ratio. Source: Federal Reserve Economic Data. Graphics: St. Louis Fed.
If we take the AS-AD model which examines the price level (average prices) and output through aggregate supply and aggregate demand we can see exactly why “constant stimulus” is dangerous. If we were in a boom time or a period in which there is enough Aggregate Demand, then any government intervention would naturally shift the line rightwards. As a result, any increase in output would naturally be limited, and offset by inflation.
We can see this phenomenon in the rise of asset price inflation. Since the 1970s, the size of financial markets has exploded from about the same size as the global economy to four times the size. Most of those gains go to the wealthy, who are the main owners of financial investments. Asset prices have been acting as an escape valve for inflationary pressures created by low interest rates and trillions worth of liquidity in the system. Both the dot-com and housing bubbles were formed during times of relatively low interest rates and high liquidity.
Another side effect of constant stimulus provided by the government is slow growth. Sluggish growth is perhaps the most worrying side effect of increased deficit spending. BCA research has shown a correlation between high spending countries and slow GDP growth. Moreover, data from the World Bank has showed that during 1981 – 2003, when government spending as a percent of economic activity declined from 24% to 19% GDP growth averaged 3.4%. Since then, as government spending has risen compared to the size of the economy, GDP growth has averaged 1.6%.
We can see this in practice in big spending countries such as Japan, a model for MMT economists. They claim that Japan is a prime example of their theory, a big spending country that has yet to receive the negative effects of high inflation or increasing interest rates. What they fail to see is that Japan is already feeling the side effects. In the past 3 decades since their constant deficit spending began, average growth has averaged a meagre 1%, hardly a success!
In the UK during the early 2010s the government attempted to reign in deficit spending to mixed success. While the social consequences of the Austerity regime were horrific and the spending cuts much too deep, the oft-maligned economic program did have some success. Economic research undertaken by 3 prominent economists showed that the program had resulted in growth that was higher than the European average, and higher than the IMF had predicted.
The reason why large deficit spending leads to sluggish growth is due to the constant stimulus provided by the government towards businesses. Stimulus during a recession is economically sound but constant stimulus has detrimental effects.
The easy money provided by the government has led to support for the least productive “zombie companies,” which would otherwise fail. Research from the OECD shows that these companies hamper growth for healthy firms and provide barriers of entry into the market for younger firms, thus hampering productivity and lowering potential growth. The lure of easy money may even disincentivise healthy companies to allocate resources effectively, which in turn also hampers productivity and hinders growth.
Slow growth is bad for the economy because it is associated with a decrease in living standards, lower tax revenue for the government and high unemployment.
The criticism of this piece lays not simply on excessive spending, but also on the allocation of such spending. As opposed to financing failing businesses, money is better spent on green infrastructure or public services.
The Greek debt crisis is an example of the turmoil that excessive deficit spending during economic booms can bring. Decades of high deficit spending from the government and misreporting of its data led to a huge fall in the credibility rating of the country. Austerity measures and tax reforms were forcibly implemented by the EU commission and the Greek economy suffered terribly under slow growth and high unemployment. Riots, protests and social unrest ensued along with the rise of populist parties. It is a harrowing case study in fiscal mismanagement.
If constant spending persists with no guardrails in sight, economic trouble may be just around the corner.
By Dev Karpe