Does increase in government budget deficit promote economic growth?

By Dr Frank Shostak

Some commentators hold that during an economic slump it is the duty of the government to run large budget deficits in order to keep the economy going. On this way of thinking, because of the increase in government outlays and the consequent budget deficit, individuals will have more money at their disposal. This in turn will result that a given dollar increase in consumer spending will lift the economy’s gross domestic product (GDP) by a multiple of the increase in consumer expenditure. 

An example will illustrate how an initial spending raises the overall output by the multiple of this spending. Let us assume that out of an additional dollar received individuals spend $0.9 and save $0.1. Also, let us assume that consumers have increased their expenditure by $100 million. Because of this, retailers’ revenue rises by $100 million. Retailers in response to the increase in their income consume 90% of the $100 million, i.e., they raise expenditure on goods and services by $90 million. The recipients of these $90 million in turn spend 90% of the $90 million, i.e., $81 million. Then the recipients of the $81 million spend 90% of this sum, which is $72.9 million and so on. Note that the key in this way of thinking is that expenditure by one person becomes the income of another person. At each stage in the spending chain, people spend 90% of the additional income they receive. This process eventually ends, so it is held, with total output higher by $1 billion (10*$100 million) than it was before consumers had increased their initial expenditure by $100 million.

Observe that the more that is being spent from each dollar, the greater the multiplier is and therefore the impact of the initial spending on overall output will be larger. For instance, if individuals change their habits and spend 95% from each dollar the multiplier will become 20. Conversely, if they decide to spend only 80% and save 20% then the multiplier will be 5. All this means that the less that is being saved the larger is the impact of an increase in overall demand on overall output. Note that on this way of thinking an increase in savings weakens the pace of economic activity. Following this way of thinking it is not surprising that most economists today are of the view that by means of fiscal and monetary stimulus it is possible to prevent the US economy falling into a recession. The magic of the multiplier however, is just dreaming – a myth. Every activity in an economy has to be funded and therefore it is always in competition with other activities for scarce savings.  Hence, within all other things being equal if more is spent on consumption goods less is left for capital goods. An increase in retailers’ activity will be offset by the decline in the activity of capital goods producers.  

Within the framework of the multiplier if overall demand in the economy weakens because of a weakening in consumer outlays, then the government must step in and boost its spending in order to prevent overall demand from declining. According to commentators, a widening of the budget deficit in response to larger government outlays can be great news for the economy. In contrast, the opponents of this view hold that a widening in the budget deficit tends to be monetized and subsequently leads to a higher inflation. So from this perspective a government must avoid as much as possible a widening in the budget deficit. In fact, the focus should always be on achieving a balanced budget. We suggest that the goal of fixing the deficit as such, whether to keep it large or trying to eliminate it altogether, could be an erroneous policy. Ultimately, what matters for the economy is not the size of the budget deficit but the size of government outlays – the amount of resources that government diverts to its own activities.   

The more government spends the more resources it takes from wealth generators

Observe that government is not a wealth generating entity – the more it spends the more resources it has to take from wealth generators. This in turn undermines the wealth generating process of the economy. This means that the effective level of tax is the size of the government. For instance, if the government plans to spend $3 trillion and funds these outlays by means of $2 trillion in taxes there is going to be a shortfall, labeled as a deficit, of $1 trillion. 

Since government outlays have to be funded it means that the government has to secure some other means of funding such as borrowing or printing money, or new forms of taxes. The government is going to employ all sorts of means to obtain resources from wealth generators to support its activities. Hence, what matters here is that government outlays are $3 trillion, and not the deficit of $1 trillion. For instance, if the government lifted taxes to $3 trillion and as a result would have a balanced budget, would this alter the fact that it still takes $3 trillion of resources from wealth generators? 

We hold that an increase in government outlays sets in motion an increase in the diversion of wealth from wealth generating activities to non-wealth generating activities. It leads to economic impoverishment. So in this sense an increase in government outlays to boost the overall economy’s demand should be regarded as bad news for the wealth generating process and hence to the economy. 

Does budget surplus contributes to national savings?

A budget surplus is seen as contributing to national savings. By generating surpluses, so it would appear, the government generates wealth, thereby strengthening the economy’s fundamentals. This argument would be valid if government activities were of a wealth-generating nature.  This is, however, not the case. Government activities are confined to the redistribution of wealth from wealth generators to wealth consumers. Government activities result in taking wealth from one person and channeling it to another. 

Various impressive projects that the government undertakes also fall into the category of wealth redistribution. The fact that the private sector did not undertake these projects indicates that they are low on the priority list of individuals. For a given state of wealth, the implementation of these projects is likely to undermine the well-being of individuals since these projects are going to be introduced at the expense of projects that are higher on the priority list of individuals. Let us assume that the government decides to build a pyramid that most individuals regard as low priority. The workers who will be employed on this project must be given access to various consumer goods to sustain their life and well-beings. Since government is not a wealth producer, it would have to impose taxes on wealth producers in order to support the building of a pyramid. 

Government taxes stifle the market process

Whenever wealth producers exchange their products with each other, the exchange is voluntary. Every producer exchanges goods in his possession for goods that he believes will raise his living standard. The crux therefore is that the exchange or trade must be free and thus reflective of individual’s priorities. Government taxes are, however, of a coercive nature: they force producers to part with their wealth in exchange for an unwanted pyramid. This implies that producers are forced to exchange more for less, and obviously this impairs their well-being. 

The more of the non-market related projects government undertakes – the more real wealth is taken away from wealth producers. We can thus infer that the level of tax, i.e. wealth, taken from the private sector is directly determined by the size of government activities. Observe that by being a wealth consumer and not a wealth producer the government cannot contribute to savings and to the pool of savings. Moreover, if government activities could have generated wealth then they would have been self-funded and would not have required any support from other wealth generators. If this were the case, the issue of taxes would never arise. The essence of what was said is not altered by the introduction of money. In the money economy the government will tax (take money from wealth generators) and pay out the received money to various individuals that are employed directly or indirectly by the government. This money will give these individuals access to the pool of savings i.e. final consumer goods. Government-employed individuals are now able to exchange the taxed money for various consumer goods that are required to maintain and to improve their lives. 

The meaning of a budget surplus in a money economy

What then is the meaning of a budget surplus in a money economy? It means that government’s inflow of money exceeds its expenditure of money. The budget surplus here is just a monetary surplus. The emergence of a surplus produces the same effect as any tight monetary policy. On this Ludwig von Mises wrote,  

Now, restriction of government expenditure may be certainly a good thing. But it does not provide the  funds a government needs for a later expansion of its expenditure. An individual may conduct his affairs in this way. He may accumulate savings when his income is high and spend them later when his income drops. But it is different with a nation or all nations together. The treasury may hoard a part of the lavish revenue from taxes, which flows into the public exchequer as a result of the boom. As far and as long as it withholds these funds from circulation, its policy is really deflationary and contra-cyclical and may to this extent weaken the boom created by credit expansion. But when these funds are spent again, they alter the money relation and create a cash-induced tendency toward a drop in the monetary unit’s purchasing power. By no means can these funds provide the capital goods required for the execution of the shelved public works. 

A budget surplus – i.e. a monetary surplus – does not automatically make room for lower taxes. Only if government outlays are curtailed, i.e. only when the government cuts the number of pyramids it plans to build will an effective lowering of taxes emerge. 

Lower government outlays imply that wealth generators will now have a larger portion of the pool of wealth at their disposal. If, however, government outlays continue to increase, no effective tax reduction is possible; on the contrary, the share of the pool of wealth at the disposal of wealth producers will diminish. Critics of smaller governments will argue that the private sector cannot be trusted to build and enhance the nation’s infrastructure. However, can Americans afford the improvement of the infrastructure? The referee here should be the free market where individuals, by buying or abstaining from buying, decide on the type of infrastructure that is going to emerge. 

If the size of the pool of savings is not adequate to afford better infrastructure then time is needed to accumulate savings to be able to secure better infrastructure. The build-up of the pool of savings cannot be made faster by raising government outlays. An increase in government spending will only weaken the pool of savings. 

Government can force non-market chosen projects it cannot make these projects viable

The government can force various non-market chosen projects. The government, however, cannot make these projects viable. As time goes by the burden that these projects will impose on the economy through higher ongoing levels of taxes is going to undermine the well-being of individuals and will make these projects even more of a burden. What about the lowering of taxes on businesses – surely this will give a boost to capital investment and strengthen the process of wealth formation? As long as the lowering of taxes is not matched by a reduction in government outlays, this will encourage a misallocation of savings. 

The emerging budget deficit is going to be funded either by borrowings or by monetary pumping. Obviously, this amounts to the diversion of real wealth from wealth generating activities to non-wealth generating activities. Various capital projects that emerge on the back of such government policy are likely to be the equivalent of useless pyramids.  

Why Government cannot be genuine borrower 

One of the ways the government employs in securing the necessary funds is by means of borrowing. But how can this be? A borrower must be a wealth generator in order to be able to repay the principal loan plus interest. This is, however, not the case as far as the government is concerned, for government is not a wealth generator – it only consumes wealth. So how then can the government as a borrower, producing no wealth, ever repay its debt? The only way it can do this is by borrowing again from the same lender – the wealth-generating private sector. It amounts to a process whereby government borrows from you in order to repay to you.  

Summary and conclusion  

A government is not a wealth generator; it relies on its sources of funding on the private sector. This in turn means that the more government spends the less savings will be available for the wealth-generating private sector. Obviously, this will impede the creation of savings and impoverish the economy as a whole. Observe that if government could generate savings then obviously it would not need to tax the private sector. The effective level of tax then is dictated by government outlays – the more government plans to spend the more savings it will divert from the wealth-generating private sector. The mode of diversion of savings from the private sector is, however, of secondary importance. What matters is that savings are diverted. The method of diverting savings can be through direct taxes or indirect taxes and by means of monetary printing. 

Another instrument for the diversion of savings is by means of borrowing. However, how can this be? After all, if a lender transfers his savings to a borrower surely this is done voluntarily. Furthermore, a lender should actually be seen as an investor. He commits his real resources in order to make a gain. This in turn implies that the borrower must be a wealth generator in order to be able to repay the original loan plus an interest. This is however, not so as far as government is concerned. For government is not a wealth generator, it only consumes wealth. So how then can the government as a borrower, which produces no wealth, ever repay the debt? The only way it can do this is by borrowing it again from the same lender – the wealth-generating private sector. It amounts to a process wherein government borrows from you in order to repay to you. 

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