Government Spending, Taxes, and Public Debt

1
Government Spending, Taxes, and Public Debt

• Professor Paul Hare
• School of Management and Languages
• Heriot-Watt University
• Contribution to Riding out the Recession are
  governments doing enough?,
• Heriot-Watt University, 30th March 30th 2009

2
Where we are now

• UK and all other advanced economies in recession
• IMF forecasting a decline in world income in
  2009, as well as a decline in world trade
• Historically low interest rates in the UK, 0.5 -
  as close to zero as makes no real difference
• UK government now expecting the government
  deficit to exceed 10 of GDP this year and next -
  some forecasters predict even higher numbers
• Unemployment rising rapidly in UK and elsewhere,
  inflation falling rapidly
• Banks still reluctant to lend, credit crisis
  still with us.

3
Diagnosis what does economics tell us?

• Aggregate demand has fallen, notably
• Personal consumption, C
• Investment, I
• Exports, E
• But government demand for good and services, G,
  has not fallen (yet) (and transfers, Tf will be
  rising)
• And the UK demand for imports, Im, has fallen.
• Hence equilibrium national income,
• Y C I G E - Im
• has also fallen hence the rising unemployment,
  etc.

4
Diagnosis (2)

• Usual remedy (based on first-year economics,
  simple Keynesian model) is to expand demand using
  either
• Monetary policy but little scope for cutting
  interest rates any further, and we dont know yet
  how effective quantitative easing will prove
  or
• Fiscal policy namely cut taxes (T) or raise
  government spending (G). The government has
  already done this in a modest way, and more might
  be done in the April budget.
• In the standard one-period model, this approach
  should work well and make the recession less
  severe.

5
But

• In reality we dont live in a one-period world.
• In practice, government deficits incurred now
  boost the public sector debt in the future.
• At the very least, this debt has to be held by
  someone (there must be willing buyers, at a
  reasonable price) and it has to be serviced
  (and possibly even repaid).
• To make this possible, at some point in the
  future tax rates have to rise and/or public
  spending (on good and services, or on transfers)
  has to come down.
• Alternatively, we need a short burst of inflation
  to reduce the real value of public indebtedness.
• What mix of these elements will prove politically
  feasible and credible in the financial markets?

6
UK public spending and revenues ( of GDP,
possible)
7
So what to do? Policy options

• Do nothing. Take the view that in time the
  economy will recover anyway (cycles are normal),
  so no urgent need for active fiscal policy (this
  still leaves the deficit quite high, but less
  problematic).
• Problem no idea how deep the recession would
  then be, or how long it could last, so
  politically and socially this is very risky.
• Re-think how to rescue the banks/financial sector
  so it costs less public funds. Focus on building
  new good banks and dont guarantee inherited
  toxic assets. This leaves more elbow room for
  active fiscal policy without deficits getting too
  big.

8
Policy options (2)

• Devise mechanisms to commit government to a path
  of taxes and spending that brings the deficit
  down to sustainable levels within five years.
• With such mechanisms credibly in place, can
  undertake fiscal expansion on a scale to get the
  economy back up towards full employment quite
  rapidly
• As soon as private sector growth resumes, need to
  rein in the deficit in line with the agreed
  commitment mechanisms.
• If we cannot devise suitable mechanisms, or they
  dont work, then fiscal expansion to deal with
  the deficit now will most likely be followed by a
  burst of inflation later. Politically, this is
  the easy option.

9
Possible ways forward?

• My preferred way forward would be a mix of 2 and
  3 above, i.e. re-think the bank rescue to make it
  cost less, then boost public spending/cut taxes,
  with a credible path towards more balanced public
  sector finances by, say 2012 or 2013.
• But given the political economy, it is hard to
  see this being accepted (e.g. by the banks).
• So the most likely way forward is closer to 4,
  increases in public spending and cuts in taxes,
  boosting the economy but also piling up more
  debt, eventually leading to a burst of inflation.