Guyana and the wider world Expansionary impact
Expansionary impact
We saw last week that despite the high level of recognition readers have for stimulus packages as an economic policy tool, what it takes to make government spending a true stimulus is not widely recognised. Stimulus packages refer to the net expansionary impact of the government budget on the overall level of economic activity. This expansionary impact is determined by the net gap between changes in government spending and taxation/revenue receipts.
Of course, this is by no means the only economic impact of a government budget. Each and every item of government spending and taxation affects economic activity in one way or another. However, the stimulus effect of any given stimulus package depends on the net increase in government spending produced by the budget.
Readers may therefore, ask: If the government budget is in deficit in a given year, does this mean that its impact on the economy is by definition expansionary? In other words does a budget deficit mean the budget stimulates economic activity? The answer is no, it depends. Consider an example: the government ran a budget deficit of $500 million dollars last year. This year it also runs a budget deficit, but this is reduced to $100 million. Although there is still a budget deficit, this year its net effect on the economy is contractionary not expansionary. Why is this the case? In order to reduce the deficit by $400 million this year (from $500 million last year to $100 million this year) the government must either reduce spending, increase taxation or a combination of both to reduce the deficit by that amount.
Thus as a generalisation we may state: If the government is running budget deficits but reducing the size of these deficits, it is pursuing a contractionary path for the budget’s effect on the economy. A similar situation holds true if the budget is in surplus. If the trend is to reduce the size of the budget surplus, even though the budget continues to remain in surplus, the net effect on the economy is expansionary.
Finally, if the budget is kept in balance continuously, with expenditure changing in lock-step with revenue, then the overall budgetary impact on the economy is neutral. Once again I remind readers that the budget affects economic activity in a myriad of ways. What we are seeking to isolate here is the net impact of overall spending and taxation on the level of economic activity.
Keynes macroeconomics
This policy tool come into use in the 1930s and is based on the revolution in macroeconomic analysis made possible by the work of John Maynard Keynes. It was indeed first introduced into the US as a means of fighting the recession/depression of the 1930s. At that time, it was called ‘pump-priming’ the economy. This is based on the analogy of old fashioned pumps, which had to be ‘primed’ before they came into full operation.
There are five broad means of financing government spending. The most widely used and best known is taxation. Second, the government call sell or lease public assets. Good examples of this are the privatisations undertaken by Guyana governments over the past two decades. Third, government can withdraw money from any special reserve funds it creates. Some persons would say the Lotto Fund is a good example.
The last two means of financing government expenditure are the most controversial, largely because of their inflationary potential. These are to print money and borrow from the public. These two means apply in large measure to deficit spending. Printing money and issuing government securities or bonds are the most notorious means. Why? Not only are they potentially inflationary, but when the government borrows from the public several unfortunate results can occur.
One is, the government can crowd out private borrowers in the market as they compete with them for funds that savers are willing to lend. It is assumed that savers would feel safer lending to governments than the private sector. Another effect is that increased borrowing from the government can drive up interest rates. In turn, by increasing the cost of acquiring investment funds, this deters/impedes private investment in the economy. As we all know the cost of funding investment is a major determinant of the willingness/ability of enterprises/individuals to invest.
What works best
We can conclude this discussion by trying to establish what lessons can be learnt from the recent application of stimulus packages. Four general rules should guide us. First, the expansionary or stimulus effect of any given package depends on the amount of what economists term as ‘idle resources’ in the economy. When resources are idle, the economy is operating below its potential output. The increased demand created by the net increase in government spending will not be met by a shortage of productive factors able and willing to go to work. This has two important side consequences. One is that it reduces the likelihood of rising prices (inflation) in response to increased government spending. Further, it reduces the chances of government activity crowding out private sector activity, since there are resources available for everyone.
The second rule is that speed is essential for combating economic downturns. The data show that over the past six decades, recessions have lasted 11 months on average in the industrialised economies. The range has been 6 to 18 months, although the present global crisis may last longer. Also in particular industrialised economies, like Japan, recession has been much longer.
Third, stimulus packages should not result in badly conceived, designed, and executed government projects. These must all satisfy project evaluation (benefit-cost) criteria. The public expects and should get value for money. The difficulty here is that economists measure the value of a project’s contribution to the economy (GDP) by its cost!
Finally, the more efficient, transparent, and participatory is the government, the more it is likely to successfully implement stimulus packages when faced with economic difficulties. Indeed this is a general rule, which applies to all state interventions in the economy.
This concludes the discussion on lessons to be learnt from the practice of stimulus packages.