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Thursday, January 2, 2020

Deficits and Economic Growth

A short note today to introduce some compelling data on government finances and economic growth.

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I recently explained how the welfare state has forced the U.S. government to change its fiscal policy, from budget balancing to perennial deficits and spending that continues to grow even as the economy grinds to a halt. When entitlement spending is designed to redistribute income, not to provide poverty relief, government sets itself up to continue, and gradually grow, its spending levels regardless of the business cycle.

Over time, this leads to budget deficits that simply do not go away. We usually point to the U.S. government for evidence, but Europe is at least as good a source of evidence as America. In fact, the European experience with crippling austerity policies in the past decade is a stark warning of what happens when you let fiscal policy be dictated by the ideology of economic redistribution (a.k.a., socialism) and not by the principles of limited government.

Most economists, brought up on textbook macroeconomics with its roots in the 1950s and Paul Samuelson's blow-out best seller, believe that deficits are a sign of fiscal stimulus, in other words policies that help the economy through recessions. They believe so in good part because the Samuelson bastardization of Keynesian economics prescribes that governments run surpluses when the economy is strong and we have full employment. However, this presupposes that government is not in the business of economic redistribution: all government can do under the Samuelson model is to provide temporary relief for the unemployed during recessions, and to spend temporarily on projects that help the economy back to growth.

Experience tells us that government efforts at spending the economy out of a recession do not work. The only circumstance under which an economy can benefit from government intervention is when it is in a depression. We have not seen this kind of macroeconomic disaster in this country since the 1930s, and it is unlikely that we ever will. It is also important to keep in mind that a government that dabbles around in the economy, getting itself into things it has no business getting involved in, could easily escalate a recession into a depression.

As a direct result of the modern structure of government spending, government deficits are no longer a stimulus to the economy, but a drag on it. In fact, if deficits were the result of fiscal stimulus as crude Keynesian theory suggests, we would see a much more complex correlation between deficits and economic growth than we do in Figure 1:

Source of raw data: Eurostat

The data in Figure 1 is from the member states of the European Union, quarterly for the period Q4 1999 through Q2 2019. (The period is the longest for which relevant raw data is available.) The observations are divided into deciles for improved illustration. Deficits are reported as share of total government spending, in current prices, while GDP growth is reported normally, adjusted for inflation.

Under the welfare state, the path to a balanced budget runs through growth, and growth only. Since the welfare state depresses growth over time, it perpetuates its own deficit.

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