Arguments Against Government Surpluses

A government surplus represents the removal of funds from the private economy with uncompensated public sector productive value creation. It is a policy recommended by those that champion “austerity economics” – however logically, this pattern is liable for encouraging systemic weaknesses and therefore future economic crisis.

It should be noted that although this blog post critiques austerity government policies, it does not argue for uncontrolled government spending. Rather, the ultimate implication is that “a” level of government deficit is not a bad thing because it helps enables economic growth (or at least does not actively damage the ability to achieve for economic growth). But if this is not politically feasible, at least target balanced government books – because at least this is not actively harming the ability for economic growth and encouraging economic crisis.

Austerity Economics
Those that champion austerity economics suggest that when governments run persistent budget deficits through increasing state borrowing, it becomes increasingly unlikely that the nation will be able to honour its debts. This scenario causes decreasing confidence in the government debt from lenders – individuals and firms that purchase government debt in the form of bonds – and is likely to eventually result in that nation being unable to raise more debt. In political climates where increasing tax revenues is difficult, the inability for governments to raise more debt prevents them from rolling debts over and hence default. Defaulting on government debt is a key signal for economic weakness and is argued to precede economic crisis.

But this line of thinking has two key problems: (i) it engages the paradox of thrift – increased saving reduces the ability for economic growth, and (ii) pursuing budget surpluses encourages compensatory private sector debt, which actively encourages the likelihood of economic crises.

Paradox of Thrift
The paradox of thrift is a Keynesian observation that one person’s spending is another person’s income – and collective reductions in spending due to collective increases in saving actively discourages economic growth: i.e. the path for economies to escape economic crises.

The reason this scenario is called a “paradox” is because although it may be desirable for individuals to be financially responsible by saving – when such saving is pursued at the aggregate level, it causes a decrease in demand. Hence, an initial collapse in demand can cause a self-sustaining collapse. Thus when governments are encouraged to pursue austerity economics, it represents a reduction in government demand and thus a reduction of incomes of those that rely on that demand. This scenario highlights that such government policies to increase their surpluses are unlikely to encourage economic growth.

However, elementary economic thinking suggests that this scenario should not be an issue – increased saving should encourage increases in aggregate lending; because there are more funds in banks to be loaned. However this logic is faulty because in reality loans are not created purely from deposits. Banks – and even non-financial firms like car dealerships, furniture companies and electronics stores – can create financial loans in isolation from their saving deposits. They extend the loans according to their own criteria. And while some nations maintain required reserves ratios (i.e. proportions of funds that have be stored at the central bank in the case of bank runs) – these reserves are not against the loan book. These reserves are a proportion of the deposits in the bank.

Private sector debt
In order for the economy to achieve economic growth whilst governments pursue budget surpluses, the private sector must be generating its own surplus in excess of the total government surplus. Unlike the public sector, the private sector cannot print more money to create this surplus. Instead, the private sector must rely on private sector banks to increase its loans to generate the surplus. These loans represent increases to private sector debt.

As has been discussed in previous posts, when private sector debt becomes unsustainable, it exacerbates Minskyian cycles – where the debt encourages systemic instability that leads to economic crisis. So we see here, that the twin pursuit of a public sector budget surplus and economic growth leads to medium/long run economic weaknesses.

This scenario can be critiqued by asking if international demand (exports) can be relied upon to plug the gap left by government budget surpluses instead. In principle, this is feasible. However in practice, this can run into a couple problems. The goods and services that governments demand are not easily replaced by foreign demand. Take an British example of reducing public sector demand for health care services, defence products, civil servants and teachers. When reducing demand for these examples to pursue a budget surplus, foreign demand is unlikely to quickly and simply match the lost demand. The health care services are required domestically, so they need to be performed domestically. Defence products are sensitive purchases that many nations make difficult to quickly purchase internationally over domestic suppliers. Civil servants and teachers can join the private sector – but they may require retraining that takes time, and besides, the international movement of labour is getting more difficult all the time.

Thus it is apparent that medium-long term economic prosperity is better served by not pursuing austerity policies. Such policies harm the ability for nations to reinitiate economic growth and can encourage long term systemic weaknesses. This blog post has not made any suggestion on what the best level of government budget because “one-size”economic growth targets do not fit all nations. Any targets should be dependent on national targets for economic growth relative to, for example given state of a nation’s current economic development.

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