Posted by: Dirk | January 17, 2009

Some thoughts on fiscal policy and government debt

After coming up with a €50 bn stimulus over the next two years, the German government is under fire. The fiscal policy would increase government and be unfair to coming generations, it is said. Increasing government debt by €50 bn would be a bad idea then. This brings us to one of the big fallacies about the economics of debt.

Government debt is financed by people who buy government bonds. It is in that way that government debts are financed. If you think this through logically you will find that the future generation will not only inherit the debt, but also the government bonds that were held by the earlier generation. Therefore, an increase in government debt is not unfair to coming generation per se. It is a problem of distribution, instead. Mostly, holders of debt are relatively rich. If they inherit more money, the distribution of the incomes will be more extreme. This probably is the real problem behind government debt.

On the other hand, people want to save money and like to invest it into riskless government bonds. Denying them the opportunity to do so may make matters worse. If instead people keep their money under the bed, the economy will be harmed. It would cause money supply to fall, or the velocity of money to decline, which means there is less money that will be spend. Since the amount of goods does not decline as well, deflation will arise. This is bad for an economy. Investment will drop (or stay close to zero), since falling future prices make investments today less profitable. Firms want to sell in the future, and if their expected prices fall, they invest less (or nothing at all).

Another issue I would like to comment on is the amount of government debt. How large is the increase in government debt if the size of the fiscal stimulus is €50 bn? If you think it’s also €50 bn, think again. Extra government spending of €50 bn will increase incomes by the same amount. That income will then be partly saved, partly consumed, partly taxed away. Let us assume that (marginal) taxes are 33 percent, saving at 10 percent and imports at 7 percent. I made these numbers up, but they are not too unrealistic. The saving rate is normally less than 10 percent, but in times like these it must be quite high. Also, of the money spend, 7 percent goes into imported goods and services and is hence gone.

So, the government spends €50 bn. That is the extra income that people earn. Of these €50 bn, €5 bn are saved. The rest is spend: €45 bn. A third of that is taxed away, so €15 bn go back directly to government. So, €30 bn is left in extra income, of which 7% go to imports. That leaves people in Germany with an extra income of around €28.2 bn. Again, this spend and creates extra incomes. And this goes on and on and on. Let us assume that in the end, the extra income created stands at €100 bn. It is double of what was first spend by the government, hence the Keynes multiplier is 2. (Note that there is no inflation, since the extra income is spend on things that would otherwise not be sold because of the depressed aggregate demand. Therefore, by the way, it would be wrong to argue that a fiscal stimulus has to have a profit higher than 0. That question is plain irrelevant: the idea is to create extra income and let people spend it on whatever they want.)

Finally coming back to the question of government debt, of the €100 bn of extra incomes created one third comes back as taxes, which is €100 bn * 1/3 = €33 bn. Also, €10 bn are created as extra savings, which might then be put into government bonds, which look very secure today. Let’s say half of savings is put into government bonds, which amounts to €5 bn. So, the government goes into debt for €50 bn and collects in extra taxes €33 bn plus finances the debt through an extra €5 bn in savings. That leaves us with a financing gap of €12 bn. This is a long way from €50bn, which is the cost of the stimulus. Fiscal policy partly pays for itself.

It is time to stop arguing about the financing of the Konjunturprogramm II and think about spending more. The offical government forecast for 2009 growth is -2 percent. That means a lot of goods and services will not be sold, and a lot of unemployment will arise. If these factors of production are not put into use, the result will be deflation. That would leave us with three scenarios for the near future: 1) a growth trap economy like Japan, with the banking system intact but bankrupt and full of wrong incentives, 2) same as 1), but only worse because the euro area breaks down due to gaps in competitiveness which can not be solved, or 3) a full-grown great depression with a fall in GDP of around 20 percent over the next 3-4  years.

What is now at stake is the size of the cake we give to future generations, not how it is distributed. And policy mistakes today cannot be corrected tomorrow: it is evidently very hard to get rid of deflation once it has arrived.

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