Chapter 9: The means of financial policy part 2




01st Neutral financial policy versus fiscal policy

02nd Is a reflation sufficient?

03rd Built-in flexibility versus autonomous economic policy

04th Anticyclical versus compensatory financial policy

05th Deficit (without) spending, spending without deficit

06th The different financing methods of the deficit

07th About the problem of public debt




05.  Deficit (without) spending, spending without deficit


Within the framework of fiscal employment policy, a distinction is made between three instruments:


·        The deficit spending, where the budget deficit is achieved by increasing expenditure at consistent tax revenues,  




·        the deficit without spending, where the budget deficit is realised by tax reductions at a consistent level of public expenditure,  



the spending without deficit, where expenditure and tax revenue are increased by the same amount.



The spending without deficit is based on the Haavelmo theorem, according to which an increase in the budget triggers expansionary effects even if the budget is balanced.


Please note that a reduction in tax revenue is not necessarily identical to a reduction in tax rates. A percentage change in a tax rate (t) by one percentage point will only result in a percentage reduction in tax revenues (T) by one percentage point if the reference value of the tax (income E or turnover U) remains constant. The formula is valid:

T = t*E


Within the framework of a comparative efficiency analysis, it must be examined how the three different ways of financing a deficit lead to varying degrees of success.


First, let us ask about quantitative efficiency: the individual instruments of fiscal policy differ firstly in the extent of their impact on income and employment.


The strongest impacts emanate from deficit spending, where the multiplier corresponds to the reciprocal value of the decommissioning rate.


The effects emanating from deficit without spending are somewhat smaller than from deficit spending, since in the first period only the disposable income rises but, in contrast to deficit spending, not the domestic product.


In the case of spending without deficit, the multiplier effect is lowest. It amounts to just one.


The easiest to explain is the multiplier of the deficit spending. We will examine the following graphic.   




We plot the domestic product (Y) on the abscissa, and on the ordinate we plot both the purchasing power creation: investment sum plus government expenditure (I+G) as well as the purchasing power decommissioning: savings sum plus tax revenue (S+T). The previous equilibrium was at Y0; we want to assume that full employment could not yet be achieved with this domestic product.  


The state would therefore increase government expenditure by DG, which would lead to - as the graphic shows -  an increase in domestic product by DY. The red line (the course of the purchasing power decommissioning (S+T)) together with the drawn coordinates form a triangle, and for this triangle the law of tangents applies, according to which tg alpha is equal to the quotient DG/DY:


Here, the tangent alpha corresponds to the decommissioning rate (s+t). Now, if we transfer both the value for the decommissioning rate as well as the value for the growth in domestic product to the other side respectively, the growth in domestic product can be determined, which is achieved due to the deficit-financed increase in government expenditure in the new equilibrium:


If households decommission a total of 25% by savings and tax payments, then an increase in government expenditure leads ceteris paribus (i.e. with constant tax revenues) to an increase in domestic product of 1/(25/100) = 1 * 4 units.


A deficit spending does not always lead to an increased demand to the extent of the multiplier developed here. This is referred to as the problem of crowding out: the increase in the demand of the government can be partly compensated by the fact that the private investment demand decreases due to interest rate increases.


The interest rate increase is triggered by the fact that the government acts as a buyer on the capital market. Increases in demand in the case of constant supply lead in general to price increases, and thus to interest rate increases on the capital market.


Thus the following equation is valid:     




Crowding out is to be expected particularly if, on the one side, the state finances the budget deficit by means of capital market funds and if, on the other side, the investments react elastically to changes in interest rates.


Keynesians recommend financing the budget deficits by central bank loans (i.e. by money creation) and were of the opinion that the investments were inelastic to interest rates. However, a financing of the budget deficit by central bank loans is prohibited by the constitution of the FRG. Due to the recently implemented amendment of the constitution, the government bodies (municipalities and federal states, and with certain restrictions also the federal government) must balance their budget every year.


With regard to the interest rate elasticity of investments, it must be reckoned with the possibility that even though declining interest rates will not trigger an increase in investment, the demand for investment will indeed decline as interest rates rise.


Now, we turn to the effect of a deficit without spending. We have seen that the deficit without spending leads to a multiplier effect which corresponds precisely to the multiplier of the deficit spending reduced by one. How do we explain this somewhat smaller effect? The best way to do this is to use a dynamic analysis.


If the state increases its deficit by one unit via reducing the tax sum by this amount, then in the first period we only have a decrease in the privately disposable income. But since consumption, according to the Robertson consumption function, depends on the privately disposable income of the previous period, there are no effects yet on the domestic product in the introductory period of the tax reduction. In the following periods, consumer demand rises and with it the income just as deficit spending. Thus, if we add up these multiplicative effects in a dynamic analysis, the multiplicative effect of deficit without spending differs from the multiplier of deficit spending by just the amount of the deficit increase.


Why in spending without deficit there can be ascertained a multiplier effect of just one has already been discussed in detail above.


Now, we turn to the question of the political feasibility of the individual instruments. Not all strategies are politically feasible in equal measure. For example, in a contractive policy, the salaries of civil servants cannot be reduced in the short term. Civil servants cannot be dismissed, and also their salaries could possibly be reduced only after the current collective agreement has expired. But the individual instruments of deficit policy cannot only fail due to the legal situation. Often politicians are not able to use certain instruments simply because they are regarded as unpopular and could frustrate electoral success immediately before elections.


Generally, of course, applies that it is politically much easier to increase government expenditures than to reduce them or to reduce tax revenues than to increase them. This means that an expansive economic policy will primarily make use of an increase in government spending and a contractive policy will primarily make use of a reduction of tax revenues.


Finally, besides the efficiency of a measure, the question must be clarified which different negative secondary effects must be expected when using these three instruments.


We have already discovered within the framework of the target analysis that primarily the aim of full employment and the aim of monetary stability conflict with each other. We saw the most important reason for this in the fact that the economic upswing in the individual branches of the economy is not synchronous. For this reason, we must reckon that individual branches of the economy have already reached their capacity limits and that the growth in demand will therefore be reflected in price increases at a time when there is still high unemployment in other branches of the economy.


The extent to which these conflicts spread depends now, among other things, on the fiscal policy instrument which used by the state to pursue its employment policy. For example, if the state wants to reduce tax revenues, there is a need for a law to be passed by parliament. For tax laws, the principle of equality before the law applies always; all citizens must be treated equally for the same facts. Thus, if the state wants to achieve its employment policy by means of tax cuts, the thereby induced increase in privately disposable income and thus also in consumer demand will always take place on a broad front.


Something else applies in the case that the government plans to stimulate the economy by increasing government spending. In this case, there is no principle that would be infringed if the government did not distribute its stimulus packages to all sectors of the economy, but rather specifically selects and financially supports individual sectors.  


Such an approach not only does not contradict the rules of a democracy, but even corresponds to an efficient procedure. Namely, if the state wanted to distribute its subsidies evenly over the entire national economy, i.e. if it applied the so-called "shotgun method", then not only efficient enterprises would be financially benefitted and kept alive, but also those enterprises which are not in a position to produce without loss. The state subsidies would prevent these enterprises from going bankrupt and would result in numerous bad investments, which would already contain the seeds of an economic turnaround.


06th The different financing methods of the deficit


In the following, we want to assume now that a state makes the attempt, in the sense of the Keynesian theory, to realise unemployment on the way to a deficit in the state budget. A deficit in the state budget can be financed here in three ways:


· Either government expenditure which is not covered by tax revenue is covered by a surplus from previous periods, or


· the state receives the necessary resources by offering debt securities on the capital market or, finally


· the deficit is financed by a loan from the central bank, thereby the amount of money in circulation is expanded in this way.


Of course, the first way of financing is only open to the government if it has previously achieved a surplus. Governments which, with Alvin Hansen, are convinced that mass unemployment is a secular problem, and which therefore suspect an insufficient demand in every period regardless of the respective economic phase, would therefore not be in a position at all to take this first way of financing the deficit.


But even if governments, with Keynes, regard macroeconomic unemployment as an economic problem, can this path only be taken if the economic stimulus package begins during the boom phase, since only during this phase there is a surplus in demand and thus the state is in a position to generate surpluses.


The method of financing mentioned in third place is often not available in practice, too. Truly, this is actually the way which Keynes himself and most Keynesians recommended. Though Keynes was of the opinion that monetary policy is not able to overcome the economic depression alone by lowering the key interest rate, the Keynesians were well convinced that expansionary fiscal policy should be supported in monetary terms, i.e. by expanding the money supply, because otherwise there would be the danger that the increased demand of the state via interest rate increases would be compensated by a reduction in private investment.


Nevertheless, the constitutions of important democratic states, such as the Basic Law of the Federal Republic of Germany, stipulate that a deficit in the state budget may not be financed by loans of the central bank. Here the danger was seen that the governments would increase their expenditures without still being controlled by the voters. In so far as the state is obliged to cover expenditure increases with tax revenues, the voter can decide for himself in his election to the parliament whether an increase in public goods promises him a greater benefit than if he spends his income on consumer goods.


If the state has the possibility to finance its expenditure via bank loans, then in the same way the share of scarce resources that is used for consumer goods is reduced, just as if the state would finance the public goods with taxes, except that this connection does not become apparent to the voter. The deficit-financed government expenditures lead to price increases and these price increases emanate directly from the suppliers of the consumer goods; it remains unclear to the voters that the real reason for these price increases lies in the increase in the share of public goods.


Therefore, as a rule only one way remains to finance deficits in the state budget: The state offers federal bonds on the capital markets and receives in this way the funds necessary to finance the deficit. Indeed, the voter does not get to know here what an increase in the share of public goods actually entails for him in the sense of a benefit loss in consumption. But at least in this case the state must find citizens who are willing to lend capital to the state, while if the budget deficits are financed by central bank loans, the state can force more or less the central bank to grant these loans.



07th About the problem of public debt


A public debt can be rejected for very different reasons. Firstly, the demand is made sometimes that the state should behave like a private household. For private households applies, however, that a long-term indebtedness is undesirable. The long-term indebtedness of a private household would always be at the expense of third parties. But this principle is not applicable to the state, since there is indebtedness within the state itself and not with third parties. After all, the state acts on behalf of the citizens and if it gets into debt, it borrows money on behalf of the community of citizens, in other words, it is practically in debt to itself.


Secondly, it is said that public debt was unconstitutional. But only certain forms of indebtedness have been unconstitutional until recently. For instance, the debt was not allowed to exceed the investment volume. We have already mentioned that a budget deficit is not allowed to be financed by central bank loans.


Recently, the Basic Law was amended to allow a government deficit only in exceptional cases (so-called debt brake). Unfortunately, this provision misjudges the fact that a strict ban on a deficit forces the state to reduce expenditure or to increase tax revenues in times of an economic downturn. But this pro-cyclical policy exacerbates the downturn. It is undesirable and for this reason even Neo-Classics, which are critical of Keynesian policy, turn against pro-cyclical policy. Neo-Classics like e.g. Milton Friedman oppose the attempt of the state to actively influence the economy via budget deficits, but they are very well of the opinion that the state should avoid anything to exacerbate the economy. A pro-cyclical policy would, however, lead to a worsening of the economic fluctuations.


A public debt can thirdly be rejected, because only with a balanced budget the politicians are subjected to sufficient control by the citizens. Increases in expenditure win votes, tax increases cost votes. Only with a balanced budget it is guaranteed that expenditure increases will only be implemented if the voters are willing to bear the thereby incurred costs in form of tax increases. In the case of deficit-financed government expenditure, the thereby resulting costs must also be borne by the citizen in the form of price increases, but the voters usually do not perceive the connection between the budget deficit and inflation.


Fourthly, public debt is also rejected on account of its inflationary effect. An increase in the domestic product leads in general to both price and volume increases.


The Keynesians assume that in the case of underemployment, increases in demand will primarily trigger growth in volume and not in price. But the more we approach full employment, the more the increases in demand will fizzle out in the form of price increases, since many markets are already showing signs of scarcity long time before full employment has been achieved in all markets.


Fifthly, public debt is often rejected also because as the budget deficit increases, the share of unproductive transfer income in the overall income rises. Only an investment of savings in venture capital leads to productivity increases. This increase in productivity is not achieved by using public debt mostly for consumption. Thus, with high, sustained public debt, the growth rate of the domestic product is likely to decline.


Sixthly and finally, public debt is rejected because it would enrich the present generation at the expense of future generations. In the present, the intended increase in domestic product may at least partly stay out because the raising of credit by the state to finance the deficit in order to increase interest rates leads to a decline in the private demand for investment.



If the debts incurred today are repaid in the future, tax increases will be necessary which reduce the privately disposable income of the future generation.


This consideration is subject to criticism, though. Referring to the total assets of the future population, there is no loss of assets, as the additional taxes are fully returned to the owners of the debt securities. A part of the future population will be burdened by the tax increase, but the asset status of the state will be improved in the way that it is reducing its debts, and the asset position of creditors will finally remain the same, since claims on the state will only be replaced by monetary assets.


But this criticism would only apply if, due to current public debt, no negative effects on the growth of the national economy were to be feared. Because if the growth rate of the domestic product is reduced due to the public debt, then the domestic product of the future generation is reduced.


A reduction in the growth rate of the domestic product must be feared for one side due to the crowding out outlined above. On the other side, it must be feared that the share of venture capital will decline as a result of public debt. In this case, however, the productivity and thus also the growth rate should decline, since productivity increases are only to be expected in the case of risk-bearing investments.