Federal Debt and GDP Growth

In a speech by Federal Reserve Chairman Ben Bernanke to the Japan Society of Monetary Economics, a few short years ago, he said

In economics textbooks, the idea that people will save rather than spend tax cuts because of the implied increase in future tax obligations is known as the principle of Ricardian equivalence.  In general, the evidence for Ricardian equivalence in real economies is mixed, but it seems most likely to apply in a situation like that prevailing today in Japan, in which people have been made highly aware of the potential burden of the national debt.

The principle of Ricardian equivalence does not apply exactly to increases in government purchases (for example, road building) but it may apply there approximately.  If, for example, people think that government spending projects are generally wasteful and add little to national wealth or productivity, then taxpayers may view increased government spending as simply increasing the burden of the government debt that they must bear.  If, as a result, they react to increases in government spending by reducing their own expenditure, the net stimulative effect of fiscal actions will be reduced.

A part of what Bernanke intimates is that government debt and government spending are closely intertwined: debt is a function of that spending.  It’s also a function of taxes, since debt results from the accumulating excess of spending over tax collection, but the primary driver of debt is that spending and not the taxes or their collection.  After all, government has immediate and proximate control over its spending, but it has only indirect control over its tax collections—through tax rates which it sets and through the strength of the underlying economy, which is impacted by that spending.

But what is the impact on the US’ economy, for instance, from Federal spending and the associated national debt?  I have some graphs below which show that, but first I want to talk a little about our GDP.

Our Gross Domestic Product, the total value of the US’ economic output—our goods and services—is estimated by a simple, third grade arithmetic formula: GDP=C+I+G+(Ex-Im), or the sum of total consumer spending, business investment, and our net exports in our international trade.  Consumer spending and business investment together comprise the bulk of our private economy, the economy in which we and our businesses conduct our affairs.

Using this formula, many economists will insist that increases in government spending, perforce, increases GDP, and based on this formula they’re right.  However, the formula, far from being merely simple, is actually simplistic: it ignores the interactions between government spending and private economy activity—those interactions of which Bernanke spoke.

One further point: this formulation measures GDP in terms of the value of the goods and services, not the volume of production of these, which would be another measure of national economic activity.  By measuring GDP in terms of pricing, the measure is made susceptible to distortion through inflation.  By inflating prices, the value of GDP can be made to seem to increase, even if actual production is not rising as quickly, is stagnating, or even is contracting.

The first of these isn’t necessarily bad; a healthy economy will see production rise, after a lag, in response to (slowly) rising prices, and this can lead to more business investment and more jobs, and more consumer spending.  But the other two are plainly the result of a shrinking or even failing economy, disguised by that overall measure.

Now let’s return to Bernanke’s remarks and look at the effect of government spending and national debt on our private economy, the total of our spending and our business’ investment.  The graphs below were developed from data collected here, here, and here, and they cover US economic history from 1900 through 2012.

The first graph below shows the per cent change, year on year, in government spending and private sector activity.

It’s easy to see that while small changes in government spending from one year to the next have little impact on the private economy, large changes—the sharp increases during the two World Wars of the last century, for instance, and the avowedly stimulative spending of 2009 and since—actually have been counterproductive in terms of facilitating economic activity in the private sector.

Those sharp increases are associated with depressed private economic activity, while large drops in government spending are associated with increases in that private activity.  In Bernanke’s terms, taxpayers simply view government spending as wasteful (the present period) and/or as future debt to be borne by them (the two war periods), and reduced their own activity—were crowded out of the overall economy—by that spending.

A careful observer might notice the Depression period and wonder at the sharp increase in government spending there, followed by an increase in private sector activity.  This, though, is an example of price rises (here, smaller decreases than expected)—inflation*—increasing the price value of GDP while actual economic activity—the volume of production—remained depressed.  Unemployment, for instance, remained at historically high levels throughout the Depression, and prices were, by Federal policy, inflated (or not allowed to decrease IAW market forces) via FDR’s wage and (farm) price controls.

The next graph shows the relationship between year to year changes in government debt and private sector economic activity.

There’s not much difference between this debt graph and the spending graph above.  That’s to be expected, though, since government borrowing is a function of government spending.  The argument for the depressive effects of large changes in government debt on the private economy apply here, also.

This last graph shows the prolonged effects of large changes in government borrowing on private sector economic activity; it compares the year to year change in government debt with the two-year change in private sector activity, thereby illustrating a more prolonged effect from government borrowing.

Now the effect is even more pronounced.  The depressive effects of government (spending and) borrowing during the Depression become clearer, for instance.  Clearer, also, is the effect of large reductions in government borrowing: private sector activity picks up sharply after a reduction has lasted long enough for crowding out effects of the underlying government spending to have time to work out of the economy and as the players in the private economy—individuals and our businesses—start to believe that the borrowing and spending actually is reducing.

Finally, there’s this view of Larry Summers, President Barack Obama’s National Economic Council at the start of Obama’s first term and one of the architects of the destructive 2009 Stimulus package of spending moves:

Mr Summers says governments should borrow more now at near-zero interest rates to invest in future growth.

Summers is ignoring the fact that these low rates are artificially low due to Fed interference in the market for the purpose of keeping interest rates low.  These artificially low interest rates harm the economy, however: they’re future inflation, they’re future taxes—even these “low cost” borrowings have to be repaid—and they inhibit capital investment, house (and other big ticket item) buying, etc by making lenders less willing to lend—they can get better returns on their money elsewhere.

These artificially low rates are a future threat to our economy, also.  By encouraging profligate borrowing of the sort Summers favors, lenders—including sovereign lenders (e.g., The People’s Republic of China, Japan, the EU, and so on)—will lose faith in our ability to repay.  They’ll stop lending until the interest rates we’re willing to pay rise to fit that risk.  In addition to this, and separate from it, they’ll take their lending renmimbi, yen, euros, etc somewhere else where they can invest them at better rates of return.


*It was a depressionary period, certainly, but the government’s moves to artificially prop up prices during that time, rather than allowing the market to clear, was (relatively) inflationary: a smaller than to be expected drop in prices is as inflationary as is a larger than to be expected rise in prices.

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