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Random Link: With Government Spending, the When Matters as Much as the How Much…

August 6th, 2011 · 11 Comments
Macroeconomics · Policy

Obviously I should have been noodling on the debt downgrade last night, but I put this out instead:

In order to begin a discussion about government spending, let’s compare two scenarios:

Scenario 1: Let’s call this the “eat what you kill” scenario, although the government would prefer to call this the “balanced budget” scenario. In this scenario, the government can only spend what it takes in in taxes in any given year. (This is a bit of an oversimplification since the government can’t actually know in advance how much it will collect in taxes, but just go with me here. I suppose this issue could be overcome by spending in a given year what was received in taxes the year before.) The reality of the world is that economic fluctuations exist, and tax revenues are going to be higher in good times and lower in bad times. Therefore, if the government were to match spending to revenue each year, the government would spend more in good times and less in bad times.

Scenario 2: This scenario is basically the opposite of scenario 1. In scenario 2, the government spends more in bad times and less in good times. This means that the government runs a deficit in bad times and a surplus (!!) in good times. (Note that even if the government merely kept spending constant over time it would run a deficit in bad times and a surplus in good times.) Scenario 2 would be designed such that, on average, spending equals taxes, so there wouldn’t be a growing debt problem.

Given that the government uses the money it collects to provide services and transfer payments to citizens, the first approach can magnify the ups and downs of economic standard of living rather than mitigate them. To make a household analogy, since the world knows how much I love those, this situation would be as if a dad moved the family into a big house every time business was good and moved the family in to a tiny apartment every time business was bad. This family will likely never be in debt, but this situation seems somehow intuitively unreasonable. In fact, economists typically assume that people prefer consumption that is consistent over time to consumption that fluctuates from day to day or year to year. (And yes, they have data to back up this claim.)

From a utility perspective, then, it’s more efficient to have government services be consistent over time than to fluctuate wildly. In addition, it’s easier for the public to put their trust and confidence in the government when they can be reasonably certain that what they get from the government today won’t be taken away tomorrow. (I think it was Austan Goolsbee who recently pointed out that confidence is the cheapest form of stimulus, and there’s certainly something to be said for that notion.) That in itself is a decent argument for scenario 2 over scenario 1, but is there more?

One of the arguments against government spending as stimulus is that it crowds out private investment. This happens because the US usually has to borrow, i.e. issue Treasury bonds, to finance the deficit, and having the government throw its hat into the borrowing ring makes it more expensive for private companies to borrow. (In other words, increasing the demand for borrowing increases the price of borrowing, namely the interest rate.) Therefore, government attempts to stimulate the economy via deficit-financed spending makes it harder for private firms to do their parts to get the economy back on track.

Another argument against spending as stimulus is that, by employing people to complete public projects, the government is taking them away from potential private-sector employment. However, isn’t it during recessions that there are a whole bunch of unemployed people lying around? Therefore, it stands to reason that economic downturns are actually a better rather than a worse time to hire people for government projects.

This last point, in addition to the fact that people like consistency as well as the observation that interest rates are often low during recessions (which addresses the crowding-out problem), implies that scenario 2 is logistically superior to scenario 1. Simply put, if a government has discretion over when to undertake some of its projects (repairing roads and building new roads and such, for example), doesn’t it make sense, on multiple levels, to undertake these projects when people are otherwise unoccupied and the economy could use the help?

The government seems to abide by this principle on some level, since there is a decent chunk of spending that falls under the category of what are known as automatic stabilizers. Automatic stabilizers are government payments that go up in economic downturns and go down during economic booms without the government explicitly having to decide on such payments. Unemployment and welfare transfer payments are prime examples of automatic stabilizers, despite the fact that they weren’t necessarily introduced for that purpose.

Before you get all ideologically upset, note that this discussion is only about the timing of government spending and not about the overall level of spending. Note also that deficit spending during a recession implies that the government has to run a surplus during good times in order to avoid running up a constantly increasing debt. From a political perspective, however, it’s apparently pretty tough to commit to running surpluses in order to save up for the rainy day spending.

Okay, now back to the debt thing. Given that the government is trying to appeal the rating based on math errors, this is the only mental image I’ve got so far:

If you’ve looked at the windows of NYC restaurants lately, you know what I am talking about here.

Tags: Macroeconomics · Policy

11 responses so far ↓

  • 1 Punditus Maximus // Aug 7, 2011 at 8:49 pm

    Sigh…the ideological conflict isn’t about the SIZE of government. It is about the PURPOSE of government. You are implicitly assuming that the purpose of government is to serve the citizens of the country it’s in. That’s what the conflict is about. It’s about whether or not the purpose of government is to facilitate as much transfer of wealth and power as possible from persons who sell their labor to persons who do not sell their labor.

  • 2 Chuck Dolci // Aug 8, 2011 at 1:06 am

    I have always had a couple problems with Keynesian economics.

    It looks at GDP and says, if real GDP goes down the government ought to increase its expenditures to get real GDP back up.

    Problem 1: It creates an intellectual basis for “excessive” (granted – a totally subjective term – but just deal with it) government interference in the economy. It presupposes that government will step in and engage in the kind and amount of spending that will actually help the economy. Do we really think that Senator Reid of Nevada believes that preserving the taxpayer funded Cowboy Poetry Festival is essential to saving the economy – or is he really just buying votes? Some might argue that spending, ANY spending, will help. Even Cowboy Poetry Festivals.

    That brings me to problem No. 2. GDP is just a number, even GDP per capita is just a number, and it has been widely believed that the bigger the number, the better. Well, I am not so sure. The number tells us nothing about the quality of life or the extent of the freedoms enjoyed by the citizens. Are the government expenditures on things people really want, and would pay for if they were spending their own money?

    If the only goal is to get higher and higher GDP numbers, then we could just tell the government to go on a wild spending spree, spend the entire output of its citizens on whatever the government bureaucrats and politicians want. Consumer expenditures would be zero, Investment would be zero, net exports wcould be zero, but G would be everything -probably not producing anything the people wanted, but our GDP numbers would certainly look good.

    Some will argue that it is more than just the numbers – it is about unemployment, etc. OK fine, so, we have more people working (at least drawing a government paycheck) but are they producing anything people want at that price? Does that lead to either productive or allocative efficiency?
    Just my three cents worth (inflation, you know).

  • 3 Joshua // Aug 8, 2011 at 2:29 pm

    Great post! My only point is that your description of government debt on the private debt market also depends on the time – particularly, the level of unemployment and inflation at any given time.

    For example, right now we are staring at possible deflation and persistently high unemployment – and for this reason, even though our debt is pretty high, private interest rates are crazy low right now.

  • 4 Dave // Aug 9, 2011 at 10:30 am

    If the government would cut spending in good times, you may have a point. But they never do.

  • 5 Joshua // Aug 9, 2011 at 10:45 am

    Actually, Dave, take a look at the period from 1998-2000, when we actually had a surplus. It’s not ancient history.

  • 6 Nahim // Aug 11, 2011 at 12:34 pm

    @Chuck: Lower GDP doesn’t necessarily mean you’re worse off, but a fall in GDP is almost always bad. We should rightly question the merit of super-prioritizing GDP growth in the long-run, yet at the same time, a recession is still a recession and strikes the economy where it hurts- which is where Keynesian economics comes in.

  • 7 ecolad // Aug 12, 2011 at 2:08 am

    Classic argument of big govt v small govt. I believe that the ‘when’ and ‘how’ of govt spending is not nearly as important as the spending priorities. Eg, If you want to run 823 military bases worldwide, then it makes no sense to reduce taxes for the wealthy as the Bush admin did several times in the 2000s. Add to that 2 simultaneous wars, and you’ve got a recipe for a fiscal disaster since most of the financing had to come from borrowing. It makes sense, doesn’t it? If you don’t have enough domestic revenue (Tax) to fund your military, then it’s gotta come from elsewhere.

    It’s all about pririorites, which are a reflection of ideological prefences. Eg if you support small govt, then you believe that the market should be left alone(ie, increased deregulation). Well, how did deregulation go with respect to the banking sector in 2008’s GFC, and another one potentially looming around the corner? But, then again, how can anyone claim to support a ‘small govt’ when the military budget keeps increasing exponentially?

    It’s hard to see any support for slashing the military budget ($700b last year), or not bailing out “too big to fail” financial institutions, meanwhile ordinary, hardworking ppl receive little (or no) support. Again, the key word is “priorities”, not when and how much to spend. Recent govts have already proven how little they care about deficit financing, contrary to the public perception they are trying to manufacture.

    Spend when you have to, on important things (ie, people, healthcare, education) and cut back a little on less important items (military, govt subsidies to big business, etc). Is this really such a radical proposal? If you want a healthy economy, shouldn’t the govt provide its citizens with a decent health and education system first? (I mean all of its citizens, not just those who can privately afford it).

    It’s no wonder that the US is in the state that it’s in. The Govt allowed corporate racketeers on Wall St to plunge the national economy into chaos while refusing to offend them by raising taxes. It’s all about ideology and priorities ppl- not when or how to spend.

  • 8 holmegm // Aug 12, 2011 at 1:48 pm

    At this point, this sort of musing is rearranging deck chairs on the Titanic.

    The opportunities to smoothly handle this mountain of debt have long since passed.

    We’re at the bankrupt stage, and Obama’s idea of handling this is to argue with the credit reporting agencies.

  • 9 Chuck Dolci // Aug 13, 2011 at 7:53 pm

    This is a response to ecolad.
    One: facts are always helpful. Logic is nice too.

    You say “If you don’t have enough domestic revenue (Tax) to fund your military, then it’s gotta come from elsewhere. ” The same could be said for any of the thousands of transfer programs “If you don’t have enough domestic revenues to fund your welfare state, then it’s gotta come from somewhere.”

    You also state ” then it makes no sense to reduce taxes for the wealthy as the Bush admin did several times in the 2000s”. The fact is taxes were reduced only twice, and the tax cuts were across all rates, not just the so-called “wealthy”.
    Also, the tax cuts did not really cut taxes on the wealthy. Rates were cut, but after the cuts went into effect the “wealthy” paid a bigger percentage of the income tax burden than before and more people at the low end paid nothing. Don’t take my word for it, you can get the data yourself from the US Treaury Dept, and if you know how to use an Excel spreadsheet you can run the numbers yourself. Go to
    http://www.irs.gov/taxstats/indtaxstats/article/0,,id=96679,00.html
    The data is there, you can get it, if you are interested in FACTS.

    In addition, total federal income tax revenues increased in 2005, 2006 and 2007, during the period of lower rates. They fell in earlier years because there was a small recession in 2001 when Bush took office and there was a negative economic impact from the events of Sept. 11, 2001.
    See http://www.census.gov/compendia/statab/2011/tables/11s0467.pdf

    You say “…when the military budget keeps increasing exponentially?” I will just ignore that as hyperbole and not really a serious comment, since the military budget is not expanding exponentially.

    You go on “The Govt allowed corporate racketeers on Wall St to plunge the national economy into chaos while refusing to offend them by raising taxes.” All I can do is suggest that you do a little research and try to understand the causes of the financial mess we are in. A good start would be “Reckless Endangerment” by Gretchen Morgenson , et al. She does a good job of getting at the facts, but some of her “opinions” miss the mark and are inconsistent with her own findings. But a good source nonetheless

    By the way, I know this is hard to believe, but the “wealthy” do work hard for their money.

  • 10 João Pedro Afonso // Aug 18, 2011 at 12:30 pm

    It’s curious how the topic about government size creep back at these comments, when Jodi’s idea explicitly avoided that pitfall: what she’s approaching is not the size of the government but how this one must spent its average tax revenues. What is at stake here is not if these are big or small, but once seen what value it can or should get, how it must be employed.

    I found your exposition about the two scenarios very convincing, Jodi. I thank you for it. From that point of view, Keynesian economics gains an additional logical strength I didn’t saw it before. I was a believer but now, you put the thing in the realm were we can do math with it too. It makes a lot of sense. Instead of spending in good times where the economy is running strongly, stealing workers from prosper enterprises, let spent in public works in less good times, when they are cheaper because… there are less jobs and they need the works. In the process, we give some continuity to the economic cycles, and to the people jobs.

    What we really need now is to define how much to save, how much to spent. How can we calculate this?

  • 11 James C // Aug 22, 2011 at 10:31 am

    Great post, but I think there are two other factors that are extremely important in this discussion. The effects of inflation and also whether the country has it’s own currency or not. For example, a debt-to-income ratio of 100% isn’t alarming if you will be getting a job in the near future that is going to double your income.

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