Guest Post: Michael Potter Magic disappearing money and arguments against fiscal policy

Government budget surpluses result can result in the penury of the private sector, according to a media piece this week. But this argument against surpluses can easily be transformed into an argument against deficits.

The article provides a simplified example. A government surplus of $5 means the wealth of the private sector goes down from $100 to $95. The article goes on to say:

Imagine the government continues with the same budget the following year. The non-government sector now has $90 – and the year after $85.

Each year, the government would tax $5 more than it spends. What would it do with the surplus? While the article doesn’t make it clear, we could safely assume that the government would lend that $5 back to the private sector. After many surplus years, tax would consume all of the private sector and the Future Fund would grow to own everything. Socialism at last!

This argument against surpluses has a lot going for it: taxes are a transfer of wealth to the government after all. We are made worse off by taxes being too high. But the media piece — unsurprisingly — reaches the wrong conclusion: deficits are better than surpluses.

However, the argument can run in both directions: the argument against surpluses can be used to argue against deficits. A surplus means the government ends up with excess funds that it then lends to the private sector. Conversely, a deficit means the government has to borrow from the private sector. This means that businesses and households either cut back on consumption (i.e. living standards) or investment. Maybe not a worthwhile cost to pay.

Or another way of looking at it: if the government spends more than it saves, then the rest of the economy has to save more than it spends.

Regardless, neither deficits nor surpluses directly change the total amount of money in the economy, they just rearrange it. And this is supported by evidence that that public sector savings and private sector savings move in opposite directions.

By now this argument may appear vaguely familiar. Well, yes it is. This is a key argument in favour of Ricardian equivalence, which states that government deficits and surpluses are fully offset by private sector actions, and don’t have a direct effect on the economy.

The conclusion of this train of thought is that government stimulus (such as during the GFC) has no beneficial effect at all. Probably not a popular argument in on the left.

But don’t hold your breath for this argument to be pushed too hard.

Michael Potter is a research fellow in the economics program at the Centre for Independent Studies

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14 Responses to Guest Post: Michael Potter Magic disappearing money and arguments against fiscal policy

  1. Lem

    Politicians and their enablers are they greatest threat to human kind known.

  2. The Pugilist

    Another idiot espousing MMT as if it is some new tevolution in economics. It is the economics of John Law. Print it (the money), and they (the goods and services) will come.

  3. classical_hero

    The world should be very rich right now, what will all the government debt. Wait the exact opposite happened.

  4. John Comnenus

    But if you take the Milton Friedman view that all government spending is just taxation, either now or in the future, then government deficits not only take money from the tax payer now, but more importantly they forecast higher taxation in the future.

    So we will see very soon which theory works best for the country. Massive tax cuts and private sector led economic growth (the Trump solution) or massive tax increases and public sector led economic growth (the solution everyone else has tried since the GFC).

  5. The world should be very rich right now, what will all the government debt. Wait the exact opposite happened.

    Exactly, well said.

  6. John Comnenus

    Yep,

    France has had 50 years of deficit funded stimulus spending which has stimulated itself into low growth, lower living standards, poverty, terrorism and crime. Oh those sophisticated Continentals are soooooo smart.

  7. Ray

    “… if the government spends more than it saves, then the rest of the economy has to save more than it spends.”

    Not exactly, government spending can and does result in an increase in net financial flows from offshore. As a result, it is possible for the government to spend all it wants without taxing the private sector or reducing the savings available to the private sector.

    Of course, this raises a far more serious problem. Inflows on the Financial Account raise demand for the Australian dollar, resulting in an appreciation of the currency and, ultimately, adding to the loss of competitiveness of local producers, lower growth and job losses. That is why we run consistent Budget and Current Account deficits.

    In a small open economy with a chronic domestic savings shortfall, adjustments will invariably occur via the exchange rate which both accelerates and exaggerates the adverse effects of weak economic policy.

  8. Not exactly, government spending can and does result in an increase in net financial flows from offshore.

    You are correct, I reflected the gross oversimplification in the original Guardian article which (largely) ignored other countries.

  9. Andrew

    I guess that’s why everyone became so poor during the Howard6666 surpluses of 2000-2007. The Stockmarket consistently fell, household wealth fell, the diminishing private sector was reflected in falling nominal tax receipts etc. Right?

  10. Tim Neilson

    The argument against surpluses assumes that the economy is a zero sum game. The private sector won’t shrink in real terms just because the budget is in surplus. It will shrink in real terms only if the surplus is caused by taxation at damagingly high levels. (And, as John Comnenus reminds us above, ruinous levels of taxation are more likely to be a result of persistent deficits than a cause of surpluses.) If the surplus is caused by prudence, efficiency and restraint on the spending side (yes I know, but I’m talking about theory) there’s no reason why a surplus should be harmful.

  11. Ray

    The question of surplus or deficit is irrelevant to the level of economic growth. If investment occurs, leading to increases in output per capita, then we have real economic growth. It does not really matter if that investment originates from the public or private sectors. Instead, the major issue should be the quality of investment.

    Given that the public sector does not produce anything of note, spending by government should generally be regarded as deleterious to economic growth. Indeed, there is a double edge to this sword since government spending affects productivity in three ways. First, it may absorb investment which would be more effective if spent in the private sector in building productive capacity. Second, government spending discourages work effort through transfer payments and associated excessive effective marginal tax rates. Third via the regulations which invariably follow the artificial construction of a professional administrative class.

    That being said, not all government spending is non-productive. Infrastructure, for example, is vital to support productivity improvements in the private sector. Of course, not all infrastructure will add to economic growth (e.g. the NBN).

    Thus what is important here is not the existence of a budget deficit or budget surplus, or indeed, the level of government spending, but what such monies are being spent on. Unfortunately, the nature of government is such that achieving an efficient allocation of spending via the public sector probably impossible.

    Thus it is the redirection of investment from productive

  12. The Pugilist

    Thus what is important here is not the existence of a budget deficit or budget surplus, or indeed, the level of government spending, but what such monies are being spent on. Unfortunately, the nature of government is such that achieving an efficient allocation of spending via the public sector probably impossible.

    So then the question turns to which mechanism is likely to generate positive investment returns: the political system or the market process? This is what MMT completely misses (ignores? misrepresents?). That is why behavioural economics and the mainstream view of ‘market failure’ is so flawed. None of these schools of thought acknowledge the flaws of government nor the lack of an omnipotent, omniscient, benevolent dictator. I laugh at how the nanny staters decry the assumptions of rationality and walrasian tattonment but do not qiestion their own howler!

  13. Ray

    I realize that I did not finish my comment. So to continue.

    Thus it is the redirection of investment from productive activities to non-productive transfer payments, bureaucratic salaries and poor infrastructure investments which result in a loss of welfare.

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