Friday, 18 January 2013

Lerner's Functional Finance Part II

Continuing on from my previous post about Lerner’s Functional Finance, we now look at the effects of government expenditure.

This equation can be used to determine the changes in gross public debt to GDP ratio:
Source: Hart, N 2011, ‘Macroeconomic Policy and Abba Lerner’s System of Functional Finance’, Economic Papers, vol. 30, no. 2, pp. 210.

From the equation, an increase in G will increase Y, by the amount of increase in G multiplied by the fiscal multiplier for the planned policy. This will then lead to an increase in T, thus the Gt – Tt (the budget deficit) is not increased by 1 X ∆G but ∆G - ∆Tt, where:

∆G = change in government expenditure as a result of the fiscal stimulus
Tt = change in tax receipt as a result of the fiscal stimulus

As mentioned in this post and the previous post, the fiscal multiplier is very important in determining the effectiveness of government spending and this fiscal multiplier depends on a lot of factors such as the design of the stimulus (the spending components involved), the structure of the economy, and consumer and business sentiments. In US and Australia, where infrastructures lags behind a lot of countries such as South Korea, Japan and China, spending on infrastructures have a very large multiplier. From this post by Noah Smith, it showed a table from a NBER working paper by Alan Auerbach and Yuriy Gorodnichenko estimating the effect of government expenditure on consumption and investment for the US:
The important thing to take note here is that although investment spending has a larger multiplier than consumption spending, it has less immediate effects on the economy. Thus if the government wishes to stabilise the economy (stabilising the lost in income due to increase in unemployment) immediately when the economy faces a downturn, consumption spending works better but it does not necessarily “pay for itself”[1] in the long run, while investment spending (such as building roads, railways, investing in education, health) provides longer term benefits such as productivity gains, reducing unemployment in the longer run, and it is very likely to “pay for itself”.

Consumption spending also has one other very important effect which investment spending lacks; this effect is the stabilising of consumer and business sentiments in a downturn. The earlier and quicker the stimulus is enacted when an economy faces downturn, the less consumer and business sentiment falls, as demand for goods and unemployment is stabilised (even if it’s for a short term). This will reduce the output gap and making it less “expensive”[2] for the government to stabilise the economy with stimulus spending. If a stimulus in a recession lacks short term stabilising effects and/or took too long to implement, not only the output gap will be larger (thus needing a larger stimulus), but it will have significant social cost (cost of unemployment to households) and business investment will also take longer to recover if decision makers in businesses are uncertain about future economic prospects.

While the fiscal multiplier is important, its size should never be the main determinant of whether a government is to implement a fiscal stimulus or not. The most important determinant should always be whether if the economy is in full employment. If President Obama does not want to use the 14th Amendment and the $1 trillion dollar platinum coin option is out, there needs to be a plan which the US government will need to enact to avoid further austerity (when it is in fact, the austerity currently enacted by the government that is dragging down the economy) and implement stimulus. At the moment, the US government is failing miserably to provide prosperity to its population despite the GFC, when employment to population ratio have no yet recovered to pre-crisis level for more than four years from the crisis.



[1] “Pay for itself” refers to a situation when an increase in nominal public debt led to a reduction in public debt as a % of GDP. There are examples of raw statistic correlation in the previous post.

[2] “Expensive” only in a sense that if the government decides not to print national currency to finance its spending. Neil Hart argues in his paper (cited above) that the significance of the ability to print national currency changes the whole debate of the “debt crisis” (if this actually exists outside the European Monetary Union and other countries which do not have its own national currency). In specific:


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