The social cost of deficit spending

8 Aug

In a recent article, Robert Barro, professor of economics at Harvard, takes up the problem of the US debt deal and its long term consequences. He chides the Obama administration for using an “unrealistically high” spending multiplier when predicting the effects of its expenditures on the national economy. The concept of the multiplier, developed by economists Kahn and Keynes, claims that government spending will add something more to the economy than just debt. The sum, if you like, is more than the value of its parts: individual “pump priming” government projects will together push the private sector to start investing again, with the multiplier a measure of how much more production can result from a given amount of government stimulus. In practice, 800 billion US dollars have been channeled into the economy via the Fed’s quantitative easing policy, with more in the pipeline, and yet the US economy remains in the doldrums. As Barro points out, this spending is now having a contractionary effect on the economy as it takes the form of an unwieldy debt burden.

A standard critique of Keynesian pump priming is that its long-term impact is nil and all it does is burden individuals with higher taxes as governments seek to pay off their debt. Another is that spending by the state has the effect of “crowding out” private sector investment. This presumes that there is a dynamic private sector out there, being stifled by government intervention – one of the main arguments made for rolling back the British state in the early years of Thatcherism in the 1980s.

Whether or not there is a dynamic private sector in the US being held back by the Fed’s quantitative easing will be a matter for future posts. For the moment, it is worth considering Barro’s proposal for dealing with the US debt burden. His arguments illustrate well the way in which the effects of pump priming can be regressive in the long run, hitting those very people neo-Keynesians think they are helping. Barro recommends that reducing the US debt burden should start with setting US corporate tax and estate rates at zero. He also argues for the phasing out of tax expenditure ideas, like tax preferences for home-mortgage interest and employee fringe benefits. He also recommends the lowering of the structure of marginal income tax rates, stressing that rates on higher incomes are already high enough. His final recommendation is perhaps the most important: a flat-rate value added tax. A rate of 10%, he writes, would raise about 5% of GDP.

Barro’s proposals are highly regressive. It would represent an added tax burden for lower earners relative to higher earners. The rightwing critique of government spending is that it only leads to higher taxes. But the bit they don’t mention is that those taxes, when they come around, will hit lower earners hardest. It may seem crazy to be talking about cutting spending during a recession but increasing spending is no solution either. As well as failing to stimulate an anemic private sector, it risks leaving lower earners with the burden of paying off the debt. Austerity budgets may be no solution, but neither is pump-priming.

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2 Responses to “The social cost of deficit spending”

  1. Elias Isquith August 9, 2011 at 1:27 am #

    I’m a new reader, so apologies if this is the kind of thing regulars know well by now but: if cutting and spending are ill-advised, what is a good idea?

  2. The Current Moment August 9, 2011 at 7:08 am #

    A good question. The real problem seems to be a lack of growth, resulting from a private sector unwilling to invest. The problem with both cuts and government spending is neither are effective in stimulating further production. In so far as businesses are making profits, these are not being channeled back into new investment but rather are being paid out in the form of high salaries for executives or to shareholders as dividends. Growth is also impeded by some cultural factors, such as a fear of environmental consequences of expanded production. Whether these cultural factors are the main constrain upon production, or whether objectively the problem is a lack of profitability within the private sector, needs to be determined by looking at the figures, which is what we’re trying to do at the Current Moment. Working out what is going on seems the best way to then come up with solutions.

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