More featuring David Sharp»

by David Sharp, Founding President of the Australian Adam Smith Club (Melbourne) and author of Economic Simplicities

Throughout the world, the level of government spending, since the turn if the century, has risen significantly. This is generally the case in the developed economies, and for the major developing economies also. In Australia, since 2008 the increase in the level of government spending has been one of the fastest growing in the world. We can seek to ascertain why this so, and what might be the likely consequences.

Conflicting Economic Theories
Arguments concerning the desirability and benefit of government spending constitute a, if not the, major area of dispute between Keynesian and Keynesian influenced schools of economics on the one hand, and Classical economics and its derivatives, including the Austrian school, on the other. Keynesian and Keynesian influenced economists regard government spending as a crucial part of any appropriate economic policy. In particular, in times of an economic downturn, they believe governments should increase their levels of expenditure and incur a deficit. Such increased spending will boost aggregate demand and the consumption of goods and services. This in turn will lead to increased employment and greater production, and restore growth to the economy.

Classical economists and the followers of those schools derived from Classical economics regard increased government spending in times of economic contraction as actually harmful to the economy, since it takes resources away from the private sector, which is the sector more responsive to what is required and more effective in dealing with it. In their view, in times of economic contraction the appropriate economic policy is rather to slash government spending.

Economists classify and divide spending into two types, namely for consumption and for investment. Keynesian doctrine holds that the amount of spending for consumption is essentially predetermined and forms a stable proportion of total income. Spending for investment however can vary significantly. J M Keynes, after whom the school is named, himself famously attributed the tendency for the occurrence of such variation to mankind’s inherent animal spirits. An abundance of animal spirits in a community led to greater spending for investment and could, if uncontrolled, result in inflation. Conversely, a shortfall in animal spirits in a community led to hoarding and an under-spending on investment, and the advent of a recession. However the government’s ability to spend meant that by running a deficit more money was injected by the government into the economy and a recession avoided. Inflation, supposedly resulting from an overspent economy, would seem to have required Keynes consistently to call for a reduction in government spending. Keynes however did not propose such course, suggesting instead that, in such circumstance, government should reduce the ability of the community to overspend by increasing taxation and running a budget surplus.

As originally claimed by Keynesian theory, recession and inflation were mutually exclusive; it was not possible for them to occur together. A recession carried with it the implication that there were idle resources, land, labour and capital, within the economy. It was argued that inflation could not occur until such idle resources had been employed or restored to productive use; the so called theory of idle resources. Keynes had written his seminal work, The General Theory of Employment, Interest and Money, wherein he expounded his theory, in 1936, after the crash of 1929 had triggered the Great Depression, and a few years after governments, particularly the US government, had begun to implement what were, in effect, similar policies to that which Keynes then advocated. The book created a revolution in economic thought and within a short time Keynesianism became the worldwide dominant economic theory. It promised permanent prosperity without inflation. Keynesianism received a significant setback however following the recessions of the seventies and early eighties, which brought with them stagflation, ie inflation and recession occurring together. It became clear that the theory of idle resources was a myth. This had been demonstrated and predicted by British economist W H Hutt in a book of such name in 1939. In 1978, Nobel-prize winning economist Robert Lucas, and Thomas Sargent, penned an influential article foreseeing Keynesianism’s demise, entitled After Keynesian Macroeconomics. After falling somewhat into disfavour during the last 2 decades of the C20th, Keynesianism and those schools influenced by it underwent a significant revival particularly following the beginning of the GFC in 2007. Government spending dramatically increased. Much if not most of such increased spending is what is referred to as stimulus spending.

Stimulus Spending
Excluding anarchists, who see no need for government, everyone can agree that it is necessary to fund the essential functions of government. Whilst they might disagree as to just what such essential functions are, and just how large or lavishly funded they should be, government spending of at least a reasonable amount in order to perform such essential functions is generally accepted as a part of the proper ongoing cost of government. Stimulus spending, however, is government spending intended to restore an economy to a pre-recession level of wealth creation. Its primary goal is not the fulfilling of some task necessary for government to perform in order to increase overall wealth and productivity, but rather to create employment and put unused resources to work Keynes himself advocated, if necessary, government paying the unemployed to dig holes and then filling them up again, as a way to restore prosperity. What this ignores is the cost of the funds thus spent by government, all of which must come from one of 3 sources; taxes, borrowing or the printing of money, and all of which, other than possibly in the immediate short term, have a depressing effect on the economy

In the current economic crisis, which some economists would say began in 2001, countercyclical policies intended to revive the economy have focused on increased government spending. To date, studies and the empirical evidence overwhelmingly support the view that such policies have failed to achieve their goal. Nobel prize-winning Keynesian economist Paul Krugman maintains that the stimulus packages were simply not large enough. A growing body of economists however now take the view that cutting government spending, not raising it, is the way to improve the economy.