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Government Debt and Economic Recovery

By John Freebairn - posted Thursday, 9 July 2009

The global financial crisis has both revealed and helped to instigate significant failures in the global and Australian economies. Bursting of asset price bubbles in housing and shares have stretched the balance sheets of many debt ridden households, financial institutions and other businesses. In turn, attempts to readjust balance sheets and the associated falls in incomes, and then falls in confidence, have resulted in falls in aggregate demand and increases in unemployment.

Clearly there is no easy fix to the current recession, and policy initiatives need to operate across a broad range of fronts. Within this broader context, this piece focuses on the role of government budget deficits, with expenditure running ahead of taxation receipts, as a part of a macroeconomic policy package to achieve a quicker and sustainable boost to economic activity and employment.

It is useful to evaluate three sets of underlying reasons for a government budget deficit as a policy instrument to stimulate economic growth in a recession. These are: the automatic stabiliser effect; funding socially beneficial longer term investments; and, funding an activist Keynesian pump priming stimulus. Inevitably the lines of demarcation are blurred, but the categorisation reveals quite different arguments pro and con, and a descending order of consensus support among economists and other analysts for deficits.


There is a strong consensus that running a budget deficit in times of recession to be balanced by surpluses during the boom phases of the business cycle makes for sensible economic policy. With a continuation of general taxation and expenditure policies, in a recession taxation receipts fall and expenditure rises resulting an automatic shift to a deficit. In contemporary Australia, the fall in taxation is especially marked with the fall in corporate profits, capital gains and the downturn in property transfers, but also with the slowdown in employment incomes and consumption expenditure. At the same time, a recession increases expenditure on social security payments and elsewhere. A return to more normal economic conditions has the reverse effects, with an increase of taxation receipts relative to expenditure, and these conditions automatically generate a fiscal surplus.

At least two structural changes facing the Australian economy make it difficult to assess whether the automatic stabiliser deficit component will be reversed in full. First, it is unlikely that the high commodity prices, and associated high corporate profits, of the 2000s will reappear, and arguably they could fall further to reach long term averages. Second, as shown in the Intergenerational Reports released by the Howard government, demographic change and technological change in medicine are projected to increase the required share of national income to maintain current social security, health and other government expenditure programs.

A portion of government expenditure has the property of an investment in capital providing returns many years, if not decades, into the future. Government investment expenditures include outlays on education and on research and development, and on physical infrastructure such as for transport and communications. The funding of many of these projects requires government intervention because of well known market failures, and in many cases they are complementary to and enhance the productivity of private sector investment. Then, funding such productive investments today by running a budget deficit improves the future productivity of the economy.

A more productive and higher income economy in the future then provides the additional capacity for future taxpayers to repay the debt incurred by current policy makers. In fact, not to undertake such investment would be at the expense of lower living standards for future generations.

However, the logical support for deficit financing of government investment expenditures requires that two key sets of conditions be met, and unfortunately they are not met in contemporary Australia. First, it needs to be established that there is a market failure such that the investment projects would not be undertaken without government intervention in the financing. The market failure reasons could include public good properties, external benefits and natural monopoly. Otherwise, the government investment expenditure largely displaces private investment, with no net gain in the aggregate capital stock, and potentially a loss in efficiency with a competitive market being a more cost effective investor than a monopoly and bureaucratic government.

Second, each project should pass an explicit and transparent benefit cost assessment to show that it is a productive investment. Clearly, the investment expenditure projects announced over the last year by the commonwealth, including in National Building Infrastructure of $22 billion and the schools building projects, and the water, roads and other projects announced by the state and territory governments, have not been formally evaluated. Stated excuses of business in confidence data represent no more than a cop-out. After all, they are government projects which ultimately are funded by taxpayer dollars. More positively, supporting analysis of the productivity of debt funded investment expenditures would provide a stronger basis for both gaining political support for, and in obtaining relatively low cost funds for, such worthwhile projects.


A potential improvement in government fiscal accountability and policy management would separate the accounts more explicitly into a set of recurrent expenditure and capital expenditure accounts. Clearly the line of demarcation is somewhat arbitrary, for example health expenditure on prevention for children is largely capital in nature, while expenditure on care of the aged is more towards a recurrent expenditure. Perhaps initially a conservative approach with just physical capital and education in the capital account would be a good starting point. All investment outlays would be supported by a publically available benefit cost evaluation, and they could be funded to a large extent by debt.  

To a large extent the foregoing argument for deficit funding of productive public investment projects is an argument to fund such projects regardless of the stage of the economic cycle. Even so, such investment could be given an anti-cyclical role. In the event of a recession, such as now, it is easier for government to gain access to resources without adding to inflationary pressures on the economy than when the economy is in the boom phase. An anti-cyclical government investment strategy would require governments to be more proactive in building up a consolidated priority list of investment projects to be quickly introduced with the onset of a recession.

The third type of government deficit fiscal strategy, in addition to the automatic stabiliser and productive investment rationales discussed above, can be called the Keynesian pump priming fiscal deficit. One of the characteristics of a recession with falling economic activity and rising unemployment is a deficiency of aggregate demand relative to a country’s productive capacity. The Keynesian model proposes a government stimulus via a combination of tax cuts and increases in own expenditure, that is an increase in government demand to fill some of the private demand gap. Generally the taxation and spending changes, and the associated deficit increase, would be temporary and withdrawn as the economy recovers. The case for such an activist fiscal policy relative to monetary policy to stimulate aggregate demand is much stronger in the current recession where there is little doubt of a recession (as compared for example with the experiences of 1997 and 2001) and monetary policy alone seems inadequate.

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About the Author

John Freebairn is the Ritchie professor of economics in the Department of Economics at the University of Melbourne.

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