Government Debt Burdens Need not Lead to Recession, says research

June 10, 2011


Economists, media, government officials and many investors are operating under the premise that fiscal adjustments to the public debt in the US and across the world will lead to slower growth.  But empirical research increasingly shows that this need not be the case, leaving a massive inefficiency and misperception in the market depending on the path taken by governments. It matters how the fiscal adjustment are made -  whether it’s waste that produced no economic benefit for the country or whether the adjustment comes from those that make investments that raise the standard of living.

Keynesians central premise is the government should spend in the absence of consumer during a recession.  It it does not take into account whether the spending is productive.  Paul Krugman, arguably the second worst economist in the world, even argued for hiring people to dig ditches and fill them up, once again falling victim to the broken window fallacy. (For an easy read on this concept that catches so many – see Henry Hazlitt’s Economics in One Lesson). The idea is that you are better off if you break your own window because you’ll have to hire people to fix it.  They believe consuming produces economic growth, and it may temporarily, but at the expense of the long term.

The reason is it complete ignores the concept the role debt. In the real world, it’s saving, investing, then consuming that raises the standard of living.  Since there are no savings,  advocates say borrow and spend, ignoring both the role of savings and productive investment. Debt can produce long term returns, but if you’re borrowing $4 to generate $1 in GDP, that is not a productive investment and should be stopped (or creditors will eventually stop you). Borrowing $6 trillion to produce 2 million jobs is not productive.  

If the government takes on higher debt, people know this money will come out of higher taxes in the future. They will reduce productive investments that will raise the standard of living in the future and this will be countered by unproductive government borrowing and spending of that money in the Keynesian world. 

The bottom line is if the government cuts waste, such as government salaries that are double equivalent private wages for the same job, transfer programs from those that produce to those that don’t, waste, and fraud, this need not lead to economic retrenchment.  

    “Broadbent and Daly (2010) conclude, “In a review of every major fiscal correction in the OECD since 1975, we find that decisive budgetary adjustments
    that have focused on reducing government expenditure have (i) been successful in correcting fiscal imbalances; (ii) typically boosted growth; and (iii) resulted in significant bond and equity market outperformance. Tax-driven fiscal
    adjustments, by contrast, typically fail to correct fiscal imbalances and are damaging for growth.

37 year Study Shows Spending Cuts, Not Tax Increases, Best for Debt, Growth, Bond, Stock Markets

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