Government Debt and Economic Recovery

But, there are good arguments pro and con an activist Keynesian fiscal deficit to stimulate aggregate demand and reduce unemployment in a recession such as now. Some of the causes of the current recession are structural problems, as well as deficient aggregate demand. To focus most of the policy attention to overcome the recession on the demand deficit and away from correcting the structural problems, including restoring business and household balance sheets and reregulating the finance industry, does no more than delay the required structural changes necessary for a sustained recovery.

The most contentious set of arguments for a Keynesian deficit concern the net effect of an increase in government expenditure and reduction in taxation on aggregate demand, or the extent to which the increase in government demand crowds out or reduces private demand.

On the positive net demand stimulus side are: the arguments of a boost to confidence and what Keynes called “animal spirits”; and, that with unused productive capacity, the extra demand will draw into production otherwise unemployed labour, capital and other resources to meet extra sales, output and employment with a further multiplier expansion of demand.

Arguments for a significant crowding out of private demand by the larger government budget deficit include: the required extra deficit funding will reallocate savings and funds from the financial sector (and then for borrowing by businesses and households) to government; and, the private sector anticipating higher taxes in the future to pay-off the debt reduce their perceived long term disposable income and so reduce their current expenditure. This later effect will be smaller the larger is the share of debt financed expenditure directed to productive investment which raises future production capacity and income.

Ultimately, the net effect of these opposing arguments on the effectiveness of a deficit funded increase in government demand on aggregate demand and employment becomes an empirical issue. Because no recession in the past is a replica of other recessions, and nor of the current recession, it is not possible to infer from the past with precision the magnitude of the multiplier of an increase in government expenditure to an increase in national income and employment.

There is a wide range of estimates reported in the literature from not significantly different from zero, that is complete crowding out, to as high as three. In the May 2009 Budget Paper Number one document, the commonwealth government used a multiplier of about 0.5 (that is the turn-around of the budget from a surplus to a deficit equivalent of about five per cent of gross domestic product, GDP, is estimated to reduce the fall in GDP by 2.75 percentage points and to reduce unemployment by 1.5 percentage points). Arguably, further increases in the budget deficit will have an even smaller net effect on aggregate economic activity and employment.