On Government Deficits

by Guinandra Jatikusumo


I am currently working on a project about formulating appropriate policies in response to the impending U.S. fiscal restraint, also colloquially known as the fiscal cliff. To avoid any form of partiality, the first paper I read was the one written by the Congressional Budget Office, a non-partisan federal agency whose specialty is in providing analysis of the federal budget of the U.S. government.

CBO’s paper reinforces my belief that Rand Paul was not simply vocalizing his Republican predecessors’ political ideology when expressing his detestation towards budget deficits. Indeed, macroeconomic models in our economic textbooks are correct in showing that deficit spending is favorable in the short run–when nobody spends, the government, in a purely economic perspective, has the authority to be the ‘spender of last resort’ by increasing spending or extending tax cuts. (Note that I am discussing this issue from a purely economic perspective without taking into account the concept of government legitimacy in welfare-redistribution. If you are a libertarian, you might disagree that boosting aggregate demand through taxing or government spending is one of the roles of the government). In the short run, no economic agents living in the present cares about the existence of public debt—none of them is concerned about the significance of the rapid ticking of the debt clock located on Manhattan’s 6th avenue.

But in the long run, as most economists and conservative politicians like Paul Ryan would argue, debt is an issue.

a. The increase in debt or the constant implementation of deficit spending, without being followed by an appropriate expansionary measure in monetary policy,  would increase interest rates and thus discourage investments in at least two ways. First, as national saving decreases, the fund available for private-investment purposes will be limited; hence it increases interest rates and disincentives investors to invest in capital-intensive projects. Second, the increase in government spending will drive the economy to produce above its natural rate, increases output, but will then crowd-out investment as interest rates rise. The private investment sector will  therefore have less share of  the country’s economic output, as short-run GDP growth is attributable to government spending, not to private investments.

b. Even in a circumstance in which expansionary monetary policy took place, debt would still be a problem. Endogenous growth models–derived from the world-famous Solow growth model–predict that the decrease in savings would lead to the decrease in capital, an input essential to long-term growth. It is not the increase of demand for goods stemming from deficit spending that promotes long-run growth. Capital accumulation, in addition to growth of worker’s productivity and technological progress, is the key to increasing an economy’s real growth rate.

c. As the paper indicates, having debt would restrict “policy makers to use [fiscal policy] to respond to unexpected challenges.” It should be noted that the ability for government to spend under debt is subject to investors willingness to purchase treasury securities during open market operations. During ‘unexpected challenges’, which I assume to be unpredicted financial crises or events that lead to a decrease in investor/consumer confidence (such as the 9/11 attacks), it is not impossible that investors would be reluctant to lend to the federal government as its government bonds or treasury securities would no longer be perceived as risk-free. This shows that excessive debt would hinder the federal government’s effort in altering its fiscal policy appropriately.

Deficit spending is therefore a temporary panacea for the business cycle. This however, does not mean that the government should not consider spending under debt at all, because the significance of the impact of the ‘panacea’ is not something that is predetermined. Additionally, some might argue that the economy is not a simple disjuncture between Keynesian and neo-classical economics: deficit spending that would bring the economy out of short-term recession would not necessarily afflict the economy in the long run. A single removal of economic disturbance in the short run, by increasing debt, might result in a positive compounding effect in the future.

Note: IMF predicts that U.S.’ debt to GDP ratio is around 70-102%, while Indonesia’s is around 24.5-25%. Imagine how massive an economic boom Indonesia would experience if President Yudhoyono were to be successful in persuading DPR to spend more. 

Irrelevant note: I honestly think Nick Jonas did great in the 25th anniversary of Les Miserables. It is indeed difficult to detach yourself from the preconception that Nick is affiliated with the Jonas Brothers when you first watch it, but once you are over it, you would realize that his voice and character fit Marius Pontmercy’s.