Government Spending, Debt and Growth.

- By Chinedu Okoye 

Synopsis:

Fiscal authorities act as a stabilizing mechanism in the goods and services market in periods of high uncertainty and slow or even negative output growth. However a level of efficiency is required if the expansion is to yield the intended benefits. Tis is because, indiscriminate deficit spending with no distinct purpose could be hyperinflationary.

A prioritized budgetary allocations according to value added on a cost-benefit basis should be the none of any effective fiscal expansion. Not doing so could lead to erratic spend and income redistribution that creates economic imbalances and Stokes inflationary pressures, rather than provide economic stability.

Fiscal expansion must be more about stabilizing and supporting the markets, with job creation as an inevitable consequence, such that the jobs created as a result add value to society. The effects of a crowding-out of private investment is more likely to occur when deficit spending carries employment as a primary goal.

Human errors and attempts at fine-tuning the economy also excerbates price level pressures quicker than would have been the case if prudence was applied.

Because of the effects on the financial and goods and services market, it remains counter-productive to apply fiscal and monetary expansionary policies simultaneously. And the nature of fiscal policy tools required is dependent on the nature and cause of the economic slump.

 

The effect of Fiscal Policy acting as a Stabilizing Mechanism:

Like the Central Bank, the Fiscal authorities act as a stabilizing mechanism, when output declines, or the economy contracts. Whilst the Central Bank intervenes or is more concerned with stabilizing the financial markets —through monetary policy, the Treasury/Finance Department (or Ministry), does intervenes directly into the goods and services market —through public spending or tax adjustments.

As mentioned in our paper Money credit and growth, just as monetary expansion to sustain and stabilize growth is accompanied by inflationary pressures so is a fiscal expansion. When spending —say on roads—  is contracted out, or a public health facility, new demand is created by the public sector, through the private sector, who would need to purchase and employ production goods, which could then filters down to consumer prices.

 

Understanding the Effects of Demand Management Policies:

 

Monetary Policy;

Whilst monetary policy affects businesses and households indirectly, through a supply of liquidity to the financial markets, which causes a rise in asset prices.

Businesses with access to the capital markets can increase their demand by financing asset positions and production costs through cheaper or more available credit. Monetary policy therefore has an indirect effect on real business activity —it only influences real business.

Fiscal Policy:

A fiscal expansion directly affects real business/industrial activity. First by creating jobs to a section of the labor market whose service are required for the nature of the project (as in health and construction workers in the roads and public health)

Since taxes is a major funding source for the government, a fiscal expansion would require an adjustment of taxes that is revised upwards, or downwards —in which case debt finances the expansion. Tax increases reduces disposable income from taxpayers, and if revise downwards, leaves the government debt-dependent to run it's budget.

Either way, the resultant effect will be that spending power is transferred from one economic agent to the other —the job creation is financed by another's taxes, or debt which the repayment would still involve some level of tax income in the future to settle . This redistribution of income creates new effective demand leading to inflationay pressures.

The Inflationary Effects of Fiscal Policy:

In our previous paper; Money, Credit and Growth; The inevitability of Inflationism in a Period of Output Growth' we established that, "the monetary system has to be such that there's an efficient mechanism that transmits new money supply more toward financing real capital and other production".

Such consideration is also required of fiscal authorities, with deficit spending, there is a need to allocate these funds (revenue + debt) to areas that yield the most societal dividends; human and infrastructural development, natural resource exploration.

This is cause, just like monetary policy, excessive fiscal policy is also inflationary, and could be counterproductive. Whilst job creation is an inevitable consequence of any government spending, efficiency and value addition should be of umost importance to policymakers.

 

Scale of Preference Budgeting;

In other to increase the value added to the economy from fiscal expansion, budgetary allocations have to be prepared according to a scale of preference where expenditures —excluding debt and staff salaries—with the most value on a cost-benefit analysis framework prioritized.

Government Spending to be effective, cannot be about creating jobs, but about stabilizing the economy with support policies, creating an environment where business have a platform to build on.

 

Income Redistribution, Stability and Growth:

A no small amount of government expenses is financed by taxes. So in someway government spending reduced disposable income and/or corporate net profits. Possible capital miss-allocations and wasteful spending transfers income from one individual or entity to another creating imbalances in the markets.

The essence of deficit spending is to redistribute income, provide stability and support growth. This can only be done when government spending targets areas that cushions the burdens on household income, stimulating aggregate demand either by creating jobs from contracts on public works, or by providing services at minimal out-of-pocket cost to the average or lower band income earner.

Value Added from Fiscal Policy:

• Spending on healthcare and education improves human development over time increasing the quality of the labor force, a necessary factor for productivity gains.

• Expenditure overheads of government departments and agencies like law enforcement, industrial regulators (NAFDAC, FMITI, NCC,  customs, etc.) help smoothen out ease of doing business, facilitating growth and ensuring fair practices.

• Subsidizing strategic industries helps to enhance local production and international competitiveness. And this could boost trade and foreign direct investments.

Delivering Growth from a point of Stability:

From an efficient fiscal policy, jobs are created, industries are supported, and income redistributed, but more importantly, development is enhanced and value created.

The fiscal authorities in doing so would complement the efforts of monetary authorities in disseminating credit and supporting capital markets.

With competent regulatory oversight ensuring safe and fair practices, law enforcement and legal framework to support intellectual property assets, a healthy and higher-skilled labor force, and government support for local businesses, private sector investment is more likely to succeed.

 

Effects on Financial Markets:

One of the critiques of fiscal expansion, besides inflation, is that of crowding-out effect—the idea that public sector investment overshadow private expenditure given that they compete for the same resources.

There's also an argument that —or a scenario where— it weighs on consumer disposable income in the present or future, and stifles growth prospects, as budgets —funded by tax and non-tax revenue— become crowded by debt servicing, requiring future generations to pay higher taxes.

This carries empirical validation, but is absent important distinctions in how said fiscal outcomes manifest across time.

Any increase in government spending is derived not just from taxes, but from (Soverign) debt which carry interest costs (ie yield on Treasuries/Bonds). And these debts are obtained from the financial markets—individual investors and and non-bank financial institutions—as private sector entities.

So, if deficit financing is to be increased, more debt would be issued, which raises the asking yield, and prices, given the increased supply of sovereign debts. Since Risk-free rates (yield on government bonds/treasuries) increase, so does overall interest on lending, making for a tight financial markets (and/or costly capital).

In a period characterized by low investor confidence from higher perceived uncertainty and risks, the demand for credit reduces with private spending. So, a prudent fiscal intervention by the government would have less of a crowding-out effect, as the demand stimulating would be lagged, leading to a slow build up of expectations and investment demand.

 

Human error Fine-tuning and Fiscal Policy Failure:

An excessive and inefficient or politicized expansion would lead to a massive crowding-out effect of private investment by public investment, inflation and debt burdens, measures which

Over the years, economic policy has seen governments attempts to fine-tune the economy, ignoring constraints and expanding fiscal and monetary policy simultaneously. This has led to a more rapid decline in the objective-exchange value of money, as country's rack up debt in an attempt to prolong or sustain prosperous times.

 

Appropriate Application of Demand Management Policies:

Because, per Minsky stability breeds instability, a long boom is naturally accompanied by price increases, and when the economy is overheated, output/income declines as aggregate demand falls (as resultant effect of uncertainty.)

Now both demand management tools have the same goal —increasing aggregate demand and output — but with different methods.

A fiscal expansion involves either; taxing and spending more, or a reducing taxes. The former creates jobs, as alluded earlier, and the latter improves disposable income, both with the aim of stimulating aggregate demand, from an increased purchasing power on aggregate.

Meaning either creating new jobs which increases the population of the earning public, or increasing more disposable income for the working population from tax deductions.

A monetary expansion involves relaxing rate and reserve requirements for, or central bank increasing the size of its balance sheet (by purchasing previously issues bonds. Both forms are aimed at improving liquidity conditions and stimulating spending —indrectly, unlike fiscal policy's direct impact—in the process.

In this scenario, the government cannot afford an increase in deficit spending because that would lead to government debt instruments (or credit demand) competing with a range of private sector debt instruments and other financial assets (eg stocks)

Applying The Demand Management Policies: The "When"

If the decline is linked to rising interest costs (i.e., higher than normal interest payments as a percentage of total payments —capital, labour, taxes interest on debt, and dividends— and not falling consumer confidence, monetary expansion would seem an appropriate response. (This is assuming an efficient financial markets linked to industry).

If the output decline is due to falling consumer confidence —which typically occurs when unemployment rises, when there's a rapid fall in disposable income, or savings increases—then an appropriate response would be to augment this fall in aggregate demand with targeted and calculated fiscal expansion.

Because liquidity preference is high, and government securities are highly liquid, the demand for —these highly liquid —government securities rises, relative to private sector securities, in financial terms, a widening yield spread. Allocating more portion of investors portfolios to government  debt instruments, provides the government with capital to finance deficit spending needed to boost aggregate demand.

This should typically be done simultaneously with a monetary contraction, or pause. For, if this is done simultaneously with a monetary expansion, the increased supply of bonds and cash pushes real interest rates down, and leads to an overheated and artificial economic growth that could a precede stagflation.

Why it is Counterproductive to pursue Fiscal and Monetary Expansion: How they Should be Employed

The government cannot be pursuing expansionary fiscal and monetary policies at the same time. An attempt at that would accelerate inflation, as both private and public sector are incentivised and funded to raise demand beyond natural limits.

The monetary expansion increases credit availability and this feeds through to asset prices, whilst the fiscal expansion adds to the demand for factors of production (capital equipment and labor), raising wages and prices of finished goods.

If the authorities decide to take the second route by reducing taxes (a fiscal expansion tool) and buying back securities (monetary expansion tool), liquidty is supplied to both the markets (in the form of bond purchases), and also households/individuals (more disposable income).

Both expansion could be disastrous in the short, Medium or long term. As it involves empowering demand increases from both the private and public sector.

If the period is marred with uncertainty, or if the fiscal expansion is done without appreciation to real output and productivity constraints, investors are most likely to choose liquidity, leading to a missalllocation of resources to government debt thereby crowding-out private investments.

The crowding-out effect can be negated by and efficient pubic sector implementation of policies. Depending on the structure and psychology of the society, a fiscal and monetary expansion would most likely lead to a stagflationary or inflationary situation. This has happened in the past.

Historical Cases of Monetary and Fiscal Expansion:

This happened in the 1960's were President Johnson in addition to massive spend on the Vietnam war, also funded heavy social programs also maintained a loose monetary policy. The outcome was an overheated demand leading to inflation by the end of the decade. This set the stage for the 1970s stagflation.

The Japanese government responded to the asset bubble collapse in the 1990s by launching heavy public spending programs to stimulate the economy while the Bank of Japan maintained artificially low rates,  providing liquidity to the markets. Japans economy entered a period of low growth and deflation.

Argentina has also been a culprit in this regard, financing large deficits with artificial money supply with monetary policy subordinated t fiscal need. The outcome was or has been a chronic inflation, currency devaluation (decrease in objective exchange-value of the Peso).

Mor recently, the Nigerian government between 2015-202, in response to the commodity price slump and loss of oil revenue and market share, kept large deficits driven by subsidy payments, and borrowing costs. The Cenrral Bank concurrently increase money supply by engaging in Ways and Means lending, and a series of interventionist credit schemes. The result was inxeeased inflationary pressures, and an undermined monetary policy credibility..

Public Sector Efficiency and Growth:

Since fiscal policy is implemented through various government agencies and departments, the efficiency at which they act on their mandate becomes very significant, especially with regards too decision-making and policy proposals.

The rate at which mortality rates are more likely to drop if the health ministry allocated resources efficiently, the literacy rate and skills level will be determined by the policy actions or inactions of the education ministry.

Spending alone doesn't guarantee economic stability, and an economy can't spend it's way into growth. But a balanced approach as we have a lluded to prior [post link] to fiscal policy that complements (ie does the opposite of) monetary policy is key to sustainable deficit financing.