Net potential

The potential pitfalls of excessive focus on public debt in times of trouble...

The logic here is simple: the number that really matters is the debt to GDP ratio. Let me say it again for emphasis - it is the debt to GDP ratio, not the absolute amount of debt, that is significant when considering the ability of future generations to pay off our debt.

A typical fiscal conservative is concerned, among other things, that governments are in danger of building up too much debt when fighting recessions, which would then have negative long term effects due to the deteriorating position of public finances. In particular, right wingers in Canada seem to share a particular proclivity to citing Rae's difficulties in the recession in the early 90s as proof that government spending is not an effective way to reduce the extremes of recession. (Actually, they say that "you can't spend your way out of recession", whereas I am rephrasing this, to make it clear that, in fact, government spending clearly reduces the extremes of recessions, at least in the short term).

The important question then, is this: does additional public spending during recessionary periods a) improve, or b) damage, long term prospects for both the health of public books and economic growth.

My argument is simple, although I do not take it as a foregone conclusion that it is correct in each case. This argument should be correctly applicable in some cases, but not in others.

Here it is: long term productivity growth, which, in the knowledge economy, is largely driven by human capital accumulation, is particularly threatened by the extremes of recessions because workers shift to sectors where their acquired skills are underused or useless.

The intuition that comes from this, in more poignant terms? Fiscal stimulus must be big enough to prevent an enormous decline in long term potential growth that would result from a misallocation of skills that would take place during an extended period of recession.

I don't typically think it's worth writing something unless it points to the fallacy of a certain school of orthodox thinking, and in this case I think it's important to be explicit about which argument I'm taking on. Let me move from the orthodox to the unorthodox in discrete steps: 1) Government spending in recessions increases public debt and prevents the markets from doing their magic of downsizing or eliminating ineffcient economic activity; 2) Economic growth continues on a trend, so a period below the trend may not be too much to stress about because there is always a rebound; 3) but recessions also eliminate jobs in otherwise healthy industries; 4) These otherwise healthy industries rely on a certain body of skills and experience to maintain ongoing economic growth, 5) The misallocation of labour skills or loss of skills over time, that occurs as people find other occupations, reduces potential GDP, and 6) MOST IMPORTANTLY, a lower potential GDP growth rate means that the debt to GDP ratio is higher, EVEN IF TOTAL DEBT IS LOWER!


So, to sum this up in a few nice words ... When private demand collapses, public stimulus can have the net effect of improving our capacity to repay future debt by ensuring that human capital, i.e., acquired skills and talents, are not destroyed for all practical purposes when shifting to other sectors.


This argument doesn't even count for (a more common argument that) the fact that public spending may improve the debt to GDP ratio, even in the short term. This is simply due to the fact that spending 2% of GDP may sufficiently prop up demand that the decline in corporate and income tax receipts will have less of an impact on the total fiscal balance cmopared to doing nothing.

Between my present argument and the more standard one, let me conclude that it is no foregone matter that public efforts to spend our way out of recession have long term negative impacts on either public finances or long term growth. This is not to deny that the orthodox arguments must be carefully considered before a government decides to prop up aggregate demand as an anti-cyclical tool. It is, as I often say, a matter of debate for any givn case. Do not let anti-Keynesian dogmatism undermine our net potential.