Debt, Growth, and Politics
Dissecting the Arguments
over the Economic Effects of
Government Debt
Robert Ricketts
Frank M. Burke in Taxation
Director, School of Accounting
Rawls College of Business
Texas Tech University
October 17, 2013
Eugene Fama on Government Spending
● Conservative economic argument against deficits is
based on the following equation:
PI = PS + CS + GS, where:
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PI = Private investment
PS = Private savings
CS = Corporate savings, and
GS = Government savings
http://www.dimensional.com/famafrench/2009/01/bailouts-and-stimulus-plans.html
Fama on Spending (cont.)
 All else equal, reduction in government saving (i.e.,
increase in government deficits) will reduce private
investment in this model.
 Reason is that deficit spending is financed with
Treasury bills (short-term) or bonds (long-term).
 Money invested in Treasury securities cannot be
invested in other activities (e.g., corporate bonds,
loans to corporations, etc.).
 Thus, in Fama’s view, government spending crowds
out private investment.
Of course …
 Fama acknowledges:
 Quantities in the equation are global.
 When foreign capital is used to purchase Treasury securities,
private investment in those foreign countries may decline, but
private investment in the U.S. is not necessarily affected.
 However, he cautions that this effect is only temporary:
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Foreign investors will eventually want their money back.
Repayment of the debt reverses the effect, taking capital out of the
U.S. economy and thereby reducing private investment in the U.S.
He speculates (in 2009) that “perhaps we can [continue to borrow
from foreign lenders] for another year or so …”
And further …
 Fama acknowledges that government can also invest
(i.e., it is false to suggest that all government
spending is negative saving):
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“Some government investments are in principle productive.”
For example, certain investments have “widespread positive
spillovers” – that is, the entire community benefits from the
investment.
For example, “because all the benefits of a good road system
are difficult for a private entity to capture without creating
inefficiencies (toll or EZ Pay booths on every corner), the
government is the natural entity to make decisions about road
building and other investments that have widespread
spillovers.”
But government investment is less
productive?
 Thus, stimulus efforts can be beneficial to the
broader economy only if:
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Stimulus is spent on public investment; and
Government investments are more productive than the
private investments they replace.
 Core conservative argument, however, is that
government investments generally are not more
productive than private investments, because
government projects are not subject to market
discipline.
Fama on Productivity of Government
Investments
 “Like all government actions, … government
investments are prone to inefficiency. To survive,
private entities must invest in projects that generate
more wealth than they cost …”
 “Even good government investment projects can
become wealth burners because their implementation
is captured by interest groups …”
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Minority/gender set-asides
Unionized labor requirements
Etc.
 Thus, government investment generally is not as
productive as private investment
Counterargument (Krugman, DeLong, et al.)
 A very important question is whether corporate
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investment is more productive than private investment.
Corporate investment is largely financed from private
consumption (which generates corporate retained
earnings).
Unemployment depresses private consumption.
In environment of high unemployment, corporations
convert retained earnings to savings rather than
investment.
For evidence consider output gap during recession (e.g.,
capacity utilization).
Consumption Drives Investment
 As noted on previous slide, consumption generates
corporate retained earnings which are either saved or
invested.
 If corporations expect demand growth, they invest
retained earnings; otherwise they save them (or
distribute them to shareholders).
 If expected future demand is growing especially rapidly,
corporations will invest private savings in addition to
retained earnings.
 Corporate investment of private savings will increase
interest rates (demand for private savings increases
price)
Interest Rates Reflect Demand for Investment
 Interest rates are thus an indicator of the demand for
capital (i.e., the desire to invest).
 Low interest rates signal low demand for capital, which in
turn signals low productive opportunities for investment.
 This is a perfect time for public (government) investment:
 Cost is relatively low; and, more importantly,
 Productivity of “displaced” private/corporate
investment is low, increasing the probability that
government investment will be more productive
than private investment.
● In economic slumps, government spending helps to
maintain necessary level of total investment.
Other Responses to Fama perspective
 Investment equation only captures financial
investment:
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Investment in human capital does not show up in Fama’s
equation – e.g., government spending on education, job
training, etc.
Same for R&D.
These non-financial investments are important drivers of
future innovation (an important driver of growth).
Private enterprise often cannot afford to invest in projects with
high risk and extra-long-term payoffs:
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Sustainable energy
Space exploration
Internet
Other Concerns—Interest Rates
 Interest rates
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Government debt may place upward pressure on
interest rates.
Effect depends on demand for capital.
When interest rates remain low in face of substantial
increases in government debt, signal is insufficient
private/corporate investment opportunities.
Government spending increases investment in
economy both directly (infrastructure) and indirectly
(consumption)
Important note: we want interest rates to increase—
monitors investment & rewards saving.
Other Concerns—Inflation
 Inflation (also influences interest rates)
Will government debt drive down the value of the
dollar?
 Effect depends on productivity of government
investment (including income support spending).
 Productive investment generates economic
growth, and therefore growth in tax revenues.
 Increased revenues allow debt payment without
printing money.
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Summary: Key points to consider in
evaluating economic policy
 Proper policy decisions depend on economic conditions.
 Unemployment represents wasting resources—i.e.,
insufficient investment & insufficient consumption, which
further reduces investment
 Key point: the effects of policy changes depend on the
circumstances in which such changes are made.
 Economy needs investment to grow. If private and
corporate investors are sidelined, the proper response of
government is to fill the void.
Current Environment
 Unemployment remains too high.
 Economy needs increased investment.
 Private/corporate investment is heavily influenced by
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consumption.
Current circumstances suggest economic problems are due to
shortfall in aggregate demand (insufficient consumption).
Thus, policy should focus on increasing demand.
In sum, we want UE to fall and interest rates to rise.
Current debate is whether this goal is best accomplished by
increasing or decreasing government spending (debt).
In my view, the Fama perspective is misguided in our current
circumstances (but that does not make him a bad person).