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Good and Bad Deficits

LONDON – “Deficits are always bad,” thunder fiscal hawks. Not so, replies strategic investment analyst H. Wood Brock in an interesting new book, The American Gridlock. A proper assessment, Brock argues, depends on the “composition and quality of total government spending.”

Government deficits incurred on current spending for services or transfers are bad, because they produce no revenue and add to the national debt. Deficits resulting from capital spending, by contrast, are – or can be – good. If wisely administered, such spending produces a revenue stream that services and eventually extinguishes the debt; more importantly, it raises productivity, and thus improves a country’s long-run growth potential.

From this distinction follows an important fiscal rule: governments’ current spending should normally be balanced by taxation. To this extent, efforts nowadays to reduce deficits on current spending are justified, but only if they are fully replaced by capital-spending programs. Indeed, reducing current spending and increasing capital spending should be carried out in lock step.

Brock’s argument is that, given the state of its economy, the United States cannot return to full employment on the basis of current policy. The recovery is too feeble, and the country needs to invest an additional $1 trillion annually for ten years on transport facilities and education. The government should establish a National Infrastructure Bank to provide the finance by borrowing directly, attracting private-sector funds, or a mixture of the two. (I have proposed a similar institution in the United Kingdom.)

The distinction between capital and current spending (and thus between “good” and “bad” deficits) is old hat to any student of public finance. But we forget knowledge at such an alarming rate that it is worth re-stating it, particularly with deficit hawks in power in the UK and Europe, though fortunately not (yet) in the US.

According to proposals agreed at an informal European Council meeting on January 30, all EU members are to amend their constitutions to introduce a balanced-budget rule that caps annual structural deficits at 0.5% of GDP. This ceiling can be raised only in a deep depression or other exceptional circumstances, allowing for counter-cyclical policy so long as it is agreed that the additional deficit is cyclical, rather than structural. Otherwise, violations would automatically trigger fines of up to 0.1% of GDP.

The UK is one of two EU countries (alongside the Czech Republic) that refused to sign this “fiscal compact,” acceptance of which is required to gain access to European bailout funds. But Britain’s government has the identical aim of reducing its current deficit of 10% of GDP to near zero in five years.

An argument commonly heard in support of such policies is that the “bond vigilantes” will demand nothing less. And the finances of some European governments (and Latin American governments in the recent past) have been so parlous that this reaction is understandable.

But that is not true of the US or the UK, which both have large fiscal deficits. And most countries were adhering to reasonably tight fiscal discipline before the crisis of 2008 undermined their banks, cut their tax revenues, and forced up their sovereign debt.

At the same time, we should not attribute current enthusiasm for fiscal retrenchment to such contingencies. At its heart lies the belief that all government spending above a necessary minimum is wasteful. Europe has its own Tea Party crackpots who loathe the welfare state and want it abolished or radically pared, and who are convinced that all state-sponsored capital spending is a “boondoggle” – just so many roads, bridges, and railway lines to nowhere that soak up their money in corruption and inefficiency.

Those who believe this are unfazed by the corruption and waste that characterizes much private-sector spending. And they prefer the total waste of letting millions of people sit idle (Brock reckons that 16% of the American workforce is unemployed, underemployed, or too discouraged to seek work) to the possibly partial waste of programs that put them to work, nurture their skills, and equip the country with assets.

One can criticize details of Brock’s case: a deeper understanding of Keynes would have given him a more persuasive response to the objection that, if state-financed projects were worth doing, the private sector would be doing them. Before long, we will have to provide answers to these questions, because the pre-slump fiscal rules that the Europeans are vainly trying to strengthen were not up to the job.

We are far from having worked out a post-recession theory of macroeconomic policy, but certain elements are clear. In the future, fiscal and monetary policy will have to work together: neither on its own can stabilize inherently unstable market economies. Monetary policy will have to do much more than it did before 2008 to restrain financial markets’ “irrational exuberance.” And we need a new, unambiguous system of fiscal accounting that distinguishes between tax-funded government spending and public spending that pays for itself.

Above all, we need to recognize that the state’s role goes beyond maintaining external security and domestic law and order. As Adam Smith wrote in The Wealth of Nations:

“The third and last duty of the sovereign....is that of erecting and maintaining those public institutions and those public works, which though they may be in the highest degree advantageous to a great society, are, however, of such a nature, that the profit could never repay the expense to any individual, or small number of individuals; and which it, therefore, cannot be expected that any individual, or small number of individuals, should erect or maintain.”

Chief among these public works, for Smith, are those that “facilitate the commerce of any country, such as good roads, bridges, navigable canals, harbors, etc.” Another piece of forgotten knowledge that Smith also mentions is the importance of education. He is right to do so, however much today’s deficit hawks seem, by their behavior, to prove the opposite.

Read more from our "In Keynes's Footsteps" Focal Point.