State spending versus common sense - Editor's Blog -

Government finances will be wrecked after the Covid-19 crisis. Does it matter?

The current big debate in economics, fuelled by the huge increases in government spending as a response to the Covid-19 crisis, is about whether there are any limits to government spending. US economics professor Stephanie Kelton argues in her book The Deficit Myth that up to the point where it causes inflation, countries with their own currencies can spend whatever they like without repercussions. This means that at a stroke the whole argument over what are sustainable debt-to-GDP and budget deficit levels disappears and a government can spend freely.

An economics-based riposte to this stance is that governments are not good at meeting inflation targets and will almost certainly overshoot them. Turning spending on is much easier than turning it off, as the latter causes disquiet in those parts of the electorate who have become used to certain entitlements. The resulting inflation undermines the value of the currency, leading to larger deficits and falling living standards as import prices rocket. In essence, a country’s wealth begins to ebb away.

Such an approach also flies in the face of moderate Keynesian thinking: that the government can and should use public spending to maintain aggregate demand through periods of economic shock, as currently, but should then put government finances back in order when growth picks up. Western governments are doing the additional spending required; the question is whether under the urgings of Professor Kelton and others they decide to abandon the second part of the project and forget about balancing the books.

In making the case against this outcome,  the common sense reply may yet win the argument over the economics case. Self-evidently, governments with well-run finances are in better shape and are having greater success in tackling Covid-19 than those with poor finances. Compare the efforts of Germany, Australia and New Zealand with those of Italy, the UK and the US. The measured and practical approach that delivers sound finances also elicits a better pandemic response in terms of good organisation and planning.

The other common sense argument against unlimited spending is that anecdotally we know that the more money governments spend, the worse the quality of that spending becomes. Regarding the long-term wealth of the country, the best use of government resources is to undertake investment spending, for example in infrastructure and research projects that are beyond the scope of the private sector. In practice, the majority of government resources are used in trying to keep up with the demands of current spending. 

A virtuous circle is when governments balance current spending, hence freeing up cash to invest in R&D and infrastructure that creates future wealth. This, in turn, leads to higher tax revenues, which enables higher levels of current spending.

The deficit myth argument is attractive to politicians because it seems to give them a get-out-of-jail-free card. Some will surely take it. But common sense tells us that the financially prudent governments will be the ones to both recover from this crisis quicker and enter the next one better prepared. 

Brian Caplen is the editor of The Banker. Follow him on Twitter @BrianCaplen

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