Dissecting the Argumentsover the Economic Effects of

Government Debt

Robert RickettsFrank M. Burke in Taxation

Director, School of AccountingRawls College of Business

Texas Tech UniversityOctober 17, 2013

Debt, Growth, and Politics

Eugene Fama on Government Spending

●Conservative economic argument against deficits is based on the following equation:

PI = PS + CS + GS, where:

PI = Private investment PS = Private savings CS = Corporate savings, and GS = Government savings

http://www.dimensional.com/famafrench/2009/01/bailouts-and-stimulus-plans.html

Fama on Spending (cont.)

All else equal, reduction in government saving (i.e., increase in government deficits) will reduce private investment in this model.

Reason is that deficit spending is financed with Treasury bills (short-term) or bonds (long-term).

Money invested in Treasury securities cannot be invested in other activities (e.g., corporate bonds, loans to corporations, etc.).

Thus, in Fama’s view, government spending crowds out private investment.

Of course …

Fama acknowledges:

Quantities in the equation are global. When foreign capital is used to purchase Treasury

securities, private investment in those foreign countries may decline, but private investment in the U.S. is not necessarily affected.

However, he cautions that this effect is only temporary: Foreign investors will eventually want their money back. Repayment of the debt reverses the effect, taking capital

out of the U.S. economy and thereby reducing private investment in the U.S.

He speculates (in 2009) that “perhaps we can [continue to borrow from foreign lenders] for another year or so …”

And further …

Fama acknowledges that government can also invest (i.e., it is false to suggest that all government spending is negative saving): “Some government investments are in principle productive.” For example, certain investments have “widespread positive

spillovers” – that is, the entire community benefits from the investment.

For example, “because all the benefits of a good road system are difficult for a private entity to capture without creating inefficiencies (toll or EZ Pay booths on every corner), the government is the natural entity to make decisions about road building and other investments that have widespread spillovers.”

But government investment is less productive?

Thus, stimulus efforts can be beneficial to the broader economy only if: Stimulus is spent on public investment; and Government investments are more productive

than the private investments they replace.Core conservative argument, however, is that

government investments generally are not more productive than private investments, because government projects are not subject to market discipline.

Fama on Productivity of Government Investments

“Like all government actions, … government investments are prone to inefficiency. To survive, private entities must invest in projects that generate more wealth than they cost …”

“Even good government investment projects can become wealth burners because their implementation is captured by interest groups …” Minority/gender set-asides Unionized labor requirements Etc.

Thus, government investment generally is not as productive as private investment

Counterargument (Krugman, DeLong, et al.)

A very important question is whether corporate investment is more productive than private investment.

Corporate investment is largely financed from private consumption (which generates corporate retained earnings).

Unemployment depresses private consumption.In environment of high unemployment, corporations

convert retained earnings to savings rather than investment.

For evidence consider output gap during recession (e.g., capacity utilization).

Consumption Drives Investment

As noted on previous slide, consumption generates corporate retained earnings which are either saved or invested.

If corporations expect demand growth, they invest retained earnings; otherwise they save them (or distribute them to shareholders).

If expected future demand is growing especially rapidly, corporations will invest private savings in addition to retained earnings.

Corporate investment of private savings will increase interest rates (demand for private savings increases price)

Interest Rates Reflect Demand for Investment

Interest rates are thus an indicator of the demand for capital (i.e., the desire to invest).

Low interest rates signal low demand for capital, which in turn signals low productive opportunities for investment.

This is a perfect time for public (government) investment: Cost is relatively low; and, more importantly, Productivity of “displaced” private/corporate

investment is low, increasing the probability that government investment will be more productive than private investment.

● In economic slumps, government spending helps to maintain necessary level of total investment.

Other Responses to Fama perspective

Investment equation only captures financial investment: Investment in human capital does not show up in Fama’s

equation – e.g., government spending on education, job training, etc.

Same for R&D. These non-financial investments are important drivers of

future innovation (an important driver of growth). Private enterprise often cannot afford to invest in projects

with high risk and extra-long-term payoffs: Sustainable energy Space exploration Internet

Other Concerns—Interest Rates

Interest rates Government debt may place upward pressure on

interest rates. Effect depends on demand for capital. When interest rates remain low in face of substantial

increases in government debt, signal is insufficient private/corporate investment opportunities.

Government spending increases investment in economy both directly (infrastructure) and indirectly (consumption)

Important note: we want interest rates to increase—monitors investment & rewards saving.

Other Concerns—Inflation

Inflation (also influences interest rates) Will government debt drive down the value of

the dollar? Effect depends on productivity of government

investment (including income support spending).

Productive investment generates economic growth, and therefore growth in tax revenues.

Increased revenues allow debt payment without printing money.

Summary: Key points to consider in evaluating economic policy

Proper policy decisions depend on economic conditions.

Unemployment represents wasting resources—i.e., insufficient investment & insufficient consumption, which further reduces investment

Key point: the effects of policy changes depend on the circumstances in which such changes are made.

Economy needs investment to grow. If private and corporate investors are sidelined, the proper response of government is to fill the void.

Current Environment

Unemployment remains too high.Economy needs increased investment.Private/corporate investment is heavily influenced by

consumption.Current circumstances suggest economic problems are due to

shortfall in aggregate demand (insufficient consumption).Thus, policy should focus on increasing demand. In sum, we want UE to fall and interest rates to rise.Current debate is whether this goal is best accomplished by

increasing or decreasing government spending (debt). In my view, the Fama perspective is misguided in our current

circumstances (but that does not make him a bad person).