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Debts and deficits: why a string of deficits does not necessarily spell the end of the world

The debate about long-term public finance and the role of government is one that is most definitely needed. However, there are two aspects to this debate that are often conflated. First, there is the issue…

What is the “optimal” level of public debt? Persistent deficits do not automatically lead to a situation where the government resembles a household under mortgage stress.

The debate about long-term public finance and the role of government is one that is most definitely needed. However, there are two aspects to this debate that are often conflated.

First, there is the issue of a sustainable public debt to GDP trajectory. It is here that the issue of the optimum size of the budget balance and whether deficits are sustainable in any sense arises.

The second aspect of debate about public finance and the role of government is the composition of the budget: the mix of expenditures and revenues required to achieve budget targets – be they deficits or surpluses – consistent with sustainable debt ratios.

As to the first of these – a sustainable debt trajectory – the first thing to note is that the time-path of the debt to GDP ratio depends on four things: the size of the budget balance (whether surplus or deficit) and whether the government needs to issue more debt in response to the budget; the starting level of debt; the interest rates effectively payable on the debt; and the growth rate of the economy.

For a sufficiently small debt-to-GDP ratio and a plausible range of interest rates payable on the debt and growth rates of the economy, the debt will not grow faster than GDP so that the debt ratio remains constant over time or declines, even with persistent budget deficits.

Indeed, as one economist, Luigi Pasinetti, noted some years ago,: “It is possible to remain [in a situation] where the public debt is either constant or decreasing [as a proportion of GDP], even with a permanent public deficit, provided that GDP growth is positive.”

Persistent deficits — either before interest payments on debt are taken account (economists call this the primary budget balance) or after they are taken into account need not lead to an outcome where the government resembles a household under mortgage stress.

This is the flawed analogy often used in political debate— and it needs to be roundly knocked on the head. A primary budget surplus or even balanced budget is not always a necessary condition for public debt to stabilise or fall as a proportion of GDP. This really does depend on the four factors referred to above.

Pasinetti also noted that the “optimal” amount of public debt as a proportion of GDP is not something that economists can pinpoint.

Economists can tell you the conditions under which the debt will or will not grow faster than GDP. But there is no economic argument – certainly that I’m aware of – which points to 30% debt to GDP being less desirable that 15%, for example. Nor is there an economic justification for the nonsensical default view that has underpinned political discussion in this country for many years: that the best public debt is no debt.

The desirable debt ratio must be considered in light of the kinds of economic and social infrastructure that are funded through that debt. In other words, the optimal debt level is much more than just an economic decision.

However, there is a qualification to be made here. There is a view put by Keynes many years ago that the recurrent side of the budget should be balanced, while deficits — if needed — should be left to capital expenditure side of the budget. Part of this view is the notion that the returns on the capital expenditures — both economic and social — take place in a longer timeframe.

For Keynes, this was also about ensuring public investment was free to meet any deficiency between investment that the private sector wanted to undertake and the level required to bring an economy to full employment.

So,although the overall size of a budget balance and its time profile may not be inconsistent with constant or falling long-term public debt to GDP ratio, a government may face difficult financing issues in funding burgeoning recurrent expenditures.

If, for example, the implications for recurrent funding of an NDIS or Gonski school reforms are likely to exceed revenue projections, questions of creating additional revenue streams or of cutting in other areas of recurrent expenditure may appear prudent.

And herein lies the second aspect to the debate about public sector financing: revenue versus expenditure.

A not-so-subtle theme in much discussion in this country for a long time has been a predilection for expenditure cuts in favour of tax changes. This reflects some fundamental views about how the economy works – views, which, in the view of the present author, are erroneous.

Clearly, there are also matters of equity at stake in the revenue and expenditure mix: that expenditure on social infrastructure (as embodied in the NDIS or Gonski) and increasing of taxes or imposition of levies to finance these measures involve justifiable redistributions.

Leaving equity issues aside though, even on economic grounds there is little or no justification for seeing budget difficulties – to the extent they are difficulties – as symptomatic of excessive expenditure rather than insufficient revenue.

This can only be justified on the grounds that government expenditures either capital or recurrent in and of themselves somehow lead to a diminution of wealth in the economy, which more than offsets the social benefit which might arise from the provision of government services.

It is a view that ignores the most basic economic concepts about how income and economic activity are generated in an economy like ours, and that governments are as capable as the private sector of generating effective demand and growth. Such a view too often also ignores a need for the revenue system to be one that serves society’s economic and social needs, rather than a plaything of the private sector.

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53 Comments sorted by

  1. Adam Butler

    Engineer and Data Analyst

    Thanks Graham for this piece. Unfortunately the jury of 'media induced public opinion' has apparently spoken VERY loudly on this issue and no amount of thoughtful reflection by an expert such as yourself can even come close to competing with the fear and deceit.

    I have yet to come across any article in the mass (bought) media that even hints that deficits are not always bad (i.e. that they are not a socialist conspiracy)......in fact all the so-called "commentary" on this topic is really hard to take.....can't wait to read about the budget in the media, its sure to be a hoot.

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    1. Felix MacNeill

      Environmental Manager

      In reply to Adam Butler

      Combine that with the 'public-sector-bad-private-sector-good' mantra (chanted to Orwell's 'four-legs-good..' tune) and it becomes impossible to engage in rational discussion, let alone rational national policy.

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    2. David Thompson

      Marketing Research

      In reply to Felix MacNeill

      Actually, the history of the post WWII world - the west (and post WWI in the former Soviet Union) gives us a hell of a lot more knowledge of the reality of economic dynamics than Keynes and Orwell had. And while that knowledge has its nuances, if forced to sum it up in a sentence 'public-sector-bad-private-sector-good' will produce a higher R^2 than any other.

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    3. Peter Carabot

      Self Employed

      In reply to Adam Butler

      From a theoretical economist point of view it might all make sense, then when you look at the real world and see Greece, Spain and half of Europe, Japan and the rest you all of a sudden discover that it's a big load of B........T
      The equation is very simple, run surpluses at all time, save money for tomorrow then use a proportion of that money to build whatever you need.! Assumption: the Government squirrels away $100, earns interest of 5% in 1 year it's $105! The same government borrows $100 at 7% they spend the money and assuming that they re-pay the whole lot in 12 months the $100 project has costed a hell of a lot more. Keynes theories are just that Theories. Good on paper and not much else. Thatcher famously said that: "Socialism fails when socialist run out of other people money"

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    4. Ted Stead

      Consultant

      In reply to Peter Carabot

      Peter, surpluses are not "savings for tomorrow". They are a flow, not a stock, and so cannot be used as a store of value for spending at a later date. Unfortunately, the mass media tends to push the uninformed "surpluses must be good" argument.

      If the government is in surplus then (with a current account deficit, like we have) by definition the private sector must be in deficit. This means the private sector must sell assets, take on debt, or endure unemployment (or combinations thereof). How can this be a good thing?

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  2. James Hill

    Industrial Designer

    And the real end of the world as we know it seems to lie in the austerity induced Global Financial Crisis which looks as if it is here to stay.
    Hasn't reached Australia yet, but Abbott is its harbinger.
    The consensus of other posters is that it is all a bit like Cassandra foretelling the Fall of Troy, no?

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    1. David Thompson

      Marketing Research

      In reply to James Hill

      If it does come to Australia it will be the Swan Financial Crisis, spending like they mugged a drunken sailor (at least a drunken sailor's money is his) for no reason at all. They completely fabricated a 'GFC' which never, ever had anything to do with Australia.

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    2. James Hill

      Industrial Designer

      In reply to David Thompson

      "Swan Financial Crisis or not Abbott does not have the economic "cojones" to prevent it , just a pathetic, facile excuse to wallow in squalour, as is to be expected in "South Timor".
      The Liberals are a long gone myth as economic managers.

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    3. David Thompson

      Marketing Research

      In reply to James Hill

      I don't doubt that. Ironically I think Turnbull will have a greater shot at the Lodge once (if) they are in government. Every time Abbott's economic ship starts to wobble, Turnbull has already built a huge and diverse cheer squad right across the country and partisan lines. It will be like Greece in the 6th c BC, when the masses would call for an aristocrat to take control as a 'tyrant' - a sort of proto "saviour".

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    4. James Hill

      Industrial Designer

      In reply to David Thompson

      Turnbull's record as a private citizen certainly does recommend him as superior national leader to Abbott.
      Imagine the result had he not been rolled by just one vote on the back of Abbott's epiphany which resulted in a religiously inspired revulsion to environmentalism as a pagan, nature worshipping sect,( which just, you know, incidentally, overturned long established liberal environmental policies taken to the 2007 election).

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    5. David Thompson

      Marketing Research

      In reply to James Hill

      James, problem is MT is loathed by a lot of the Liberal rank and vile. A bit like Rudd among parliamentary Labor. But if it meant keeping government, I'm sure they'd swallow their loathing. ;)

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    6. Ted Stead

      Consultant

      In reply to David Thompson

      Fabricated a GFC? So, just to be clear, you believe that we wouldn't have had a recession if the government hadn't given the cash handouts, pink batts, new school halls, and first home owners grant increase?

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    7. David Thompson

      Marketing Research

      In reply to Ted Stead

      No I don't.

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    8. David Thompson

      Marketing Research

      In reply to Ted Stead

      But Tes, I still would have acted conservatively, and spent as Rudd did in the first round of "stimulus". Why? We could afford to, as we were the only peeps on earth in surplus.

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    9. Ted Stead

      Consultant

      In reply to David Thompson

      David, a surplus has zero bearing on a sovereign government's ability to spend in its own currency. A surplus is not a store, or savings, of dollars which can be spent; in accounting terms it's a flow, not a stock.

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    10. David Thompson

      Marketing Research

      In reply to Ted Stead

      Ted indeed it does not. As a lad I took up coin collecting for a while. One of my more treasured pieces was a German mark note for 50,000,000 marks my dad gave me!

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    11. Ted Stead

      Consultant

      In reply to David Thompson

      David, could you explain how a 50,000,000 mark note has any relevance to a sovereign government using its fiscal capacity to avoid recession?

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    12. Peter Carabot

      Self Employed

      In reply to Ted Stead

      Neither do I, there was enough movement and heat in the economy to roll on for a couple of years. Labor has squandered money, willi-neally throwing money at things. What all of that ended up doing was to put even more heat in the economy and eventually the reserve bank had to raise Interest rates and suffocate any economic activity to the point we are now. Never mind the spin from Swan, take mining out of the equation and all other sectors of the economy have been in recession for the past 2 years.

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    13. Peter Carabot

      Self Employed

      In reply to John Phillip

      "have a CURRENT track record of incompetence." do they have one of "competence"?

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    14. James Hill

      Industrial Designer

      In reply to David Thompson

      Yes, David, you are right (I like rank and "vile").
      Turnbull is viewed as a Johnny come lately, who, unlike abbott, could not be trusted with the keys to the Liberal party skeleton closet.
      Turnbull represents a clear and present danger to the Libs, plus he was raised in semi-poverty by a sole parent.
      Just as unseemly as Billy Snedden selling newspapers for pocket money as child.

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    15. James Hill

      Industrial Designer

      In reply to John Phillip

      Not according to Overseas observers though.
      They could vote by taking their money and running, a "flight of capital", which usually follows a "current track record of incompetence".( long term state Labor administrations excepted)
      Hasn't quite happened that way at the federal level.
      They'll be preparing for takeoff if they follow the polls.

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    16. David Thompson

      Marketing Research

      In reply to James Hill

      Turnbull was actually raised in the upper middle class worlds of Vaucluse and Sydney Grammar. Very similar to Tony Abbott North Shore and Riverview world. Except Tony Abbott is the real fiscal worry. He is a big spending statist. Of course he is. He IS a Roman Catholic. Abbott should not even be in the Liberal Party. He is classic DLP.

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    17. James Hill

      Industrial Designer

      In reply to David Thompson

      Not that there is anything "wrong" with the DLP.
      But Malcolm was relatively deprived in the milieu you describe.
      Concerning the seemingly duplicitous record of the DLP, was the organisation, perhaps, criminalised by the repression of Catholics in the post war era?
      Transactional Analysis, as outlined in the book I'm OK You're OK identified the typical DLP political stance (In a defensive response to that persecution) I'm OK, You're Not OK, as a the viewpoint of a criminal.
      In other studies of…

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    18. Ted Stead

      Consultant

      In reply to Peter Carabot

      Peter, I agree some of the stimulus, while necessary, could have been better spent. However, the last RBA cash rate hike was in November 2010, and has been on the way down ever since, so it's the government, not the RBA, suffocating the economy by imposing unnecessary austerity.

      And I fully agree that while mining didn't save us from the GFC (mining employment went down during that period) it has boosted the economy considerably since. So yes, he Eastern states are in recession, and we'll be in trouble when mining investment inevitably falls off a cliff.

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  3. David Thompson

    Marketing Research

    Reading this, I can't believe that in 2013 people still cite Keynes as an authority on anything. Keynes was writing about inter-war UK. His writings had never been used profitably by governments before, so why exhume this zombie now, in a world he could never recognise?

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    1. James Hill

      Industrial Designer

      In reply to David Thompson

      "I was there with FDR in thirty three" goes that Grace Jones song.
      Try reading some Galbraith books, he was there too, and used Keynesian pump-priming with the New Deal, it was so bad that Roosevelt died in office, thirteen years later.
      The voters must have thoughtit quite "profitable" to move out of the Depression.

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    2. David Thompson

      Marketing Research

      In reply to James Hill

      "Just Give Me That Keynesian Multiplier" pumping from every speakeasy across the land during the 1932 presidential election, eh? Don't think so. The US reached its lowest in 1932. By the time FDR took the Oath of Office, recovery was already underway. Not too many mentions of "The General Theory of Employment, Interest and Money" as FDR traipsed through the Dust Bowl. Given it wasn't published in the UK until 1936, perhaps not surprising.
      By the time FDR and Elanor took another tour in 1936 for…

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    3. John Armour

      logged in via email @bigpond.com

      In reply to David Thompson

      From J.K.Galbraith's "The Great Crash 1929"...

      "In 1933, Gross National Product was nearly a third less than in 1929. Not until 1937 did the physical volume of production recover to the levels of 1929, and then promptly slipped back again"

      "Until 1941 the dollar value of production remained below 1929"

      You either seem unaware that the US slipped back into depression in 1937 or choose to ignore it.

      I suspect the latter as it cuts the rug from under your anti-Keynes fixation.

      The US was quite slow to react to the threat posed by Hitler.It was Pearl Harbour that gave things a kick-along.

      BTW, the IMF recently re-discovered "the multiplier" alive and well in the ruins of Europe.

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    4. David Thompson

      Marketing Research

      In reply to John Armour

      John, I'm sure all that is quite interesting when put in the context of something. You responded to me, but didn't connect to my post. Could you please try again?

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    5. John Armour

      logged in via email @bigpond.com

      In reply to David Thompson

      Michael, I'm looking at your reply to James Hill, immediately above my previous comment.

      This is probably what I had in mind as I wrote my response:

      "By the time FDR and Elanor took another tour in 1936 for re-election, the recovery was well in, and close to where they were in 1928. Of course, by the time, FDR puts his on The Bible for the second time in 1937, that lovely Mr. Hitler was the real "multiplier".

      English is my mother tongue. I can't see the problem.

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  4. Lee Emmett

    Guest House Manager

    'But there is no economic argument – certainly that I’m aware of – which points to 30% debt to GDP being less desirable that 15%, for example. Nor is there an economic justification for the nonsensical default view that has underpinned political discussion in this country for many years: that the best public debt is no debt.'

    So how come Tony Abbott and the LNP (and their mates at the IPA and in the media) get away with pretending public debt's terrible? If we have the misfortune to see Tony Abbott and Joe Hockey formulating budgets, we can look forward to draconian welfare spending cuts, massive public sector job losses, and if they follow Peter Costello's recipe for Queensland, privatisation of state assets and hiving off services and operations to private providers.

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  5. Jonathan Adamson

    Brain Surgeon

    Seems to me is that a major part of the problem is that we are so obsessed with money balances and put no value on things like infrastructure. For instance who is better off - a country with a billion dollar train network and a billion dollars worth of debt v a same sized country with no train system and half a billion dollars of debt.

    Only when we start measuring real assets and liabilities of Governments and countries rather than just monetary ones do these discussions have any meaning…

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  6. Ngoc Luan Ho Trieu

    logged in via Facebook

    Many thanks to Professor White for the fantastic article on public finance full of long term visions of current hot issues. On
    "...the “optimal” amount of public debt as a proportion of GDP is not something that economists can pinpoint..."
    I would think that if economic growth (defined as per capita GDP or some other definition) is the objective for fiscal managers given that they have to control inflation, unemployment and debt as proportion of GDP then forming and solving an optimization problem would give some ideas about the "optimal" amount of debt.
    I would also think that such solution would give more meaningful results with important implications for gov's formulation of fiscal policies.

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    1. John Armour

      logged in via email @bigpond.com

      In reply to Ngoc Luan Ho Trieu

      It might be fun writing equations to solve that problem Ngoc but the problem doesn't actually exist.

      Ted Stead (above) who certainly seems to have his head around the sectoral balances identity has been dropping some heavy hints.

      When people obsess over deficits I think that's like a pilot concentrating his attention on fuel consumption rather than airspeed.

      When you're driving an "economy" it's the "employment speed" that you should be watching. If you aren't achieving full employment…

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    2. Ngoc Luan Ho Trieu

      logged in via Facebook

      In reply to John Armour

      John
      Agree with your ideas. Misguided comments have also disregarded the well known paradox of thrift which I learnt. Nevertheless, I believe in the existence of harmonious economic growth and in that growth there must be an achievable most "desired" unemployment rate, inflation rate and debt/GDP ratio that gov endeavours to reach through fiscal and monetary instruments without sending the economic into chaos. Searching for harmonious would demand considerable time and effort to dig through cross countries time series data. As for the modelling part, I don't think it is insurmountable. Prof White's article gave a good foundation for the development of a doable model, I think. Well, it's time for the academics to come and help save the economy...ha ha.

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    3. John Armour

      logged in via email @bigpond.com

      In reply to Ngoc Luan Ho Trieu

      Hi Ngoc

      The "desired" unemployment rate is full employment, a job for everybody who wants to work. It used to be the norm.

      No doubt you also learned about the Phillips Curve and the supposed relationship between unemployment and inflation, and its bastard progeny the Non-Accelerating Inflation Rate of Unemployment.

      Once upon a time it was the RBA's job to maintain full employment, nowadays they see their role as using a buffer stock of unemployment to (or so they imagine) keep inflation under control.

      I find it deeply offensive as a policy.

      I heard Glen Stevens say not too long ago that the NAIRU was around 5%. But I don't know of any solid empirical evidence that ties inflation to employment in the way the NAIRU claims.

      Here's a link for you:

      http://bilbo.economicoutlook.net/blog/?p=1502

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    4. Ngoc Luan Ho Trieu

      logged in via Facebook

      In reply to John Armour

      Hi John
      Many thanks for the link to Prof Mitchell blog.
      From a labour economist's view point, the desired rate is the "full employment" rate. Agreed! It would be ideal!
      However, I doubt if full employment won't create havoc in markets, from labour market to goods&services market and to money market.
      I believe in harmony in all markets. Harmony requires gov and RBA achieve what they can within their capacity in an economy full of hazards caused by both inside and outside pressures.
      Theoretically, disregarding harmony for the economy in the long run, economic authorities can have policies to drive the economy to full employment in the short to medium runs but but I do not think such full employment is sustainable in the long run.
      Just my thoughts!

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    5. David Thompson

      Marketing Research

      In reply to John Armour

      "The "desired" unemployment rate is full employment, a job for everybody who wants to work. It used to be the norm"
      In fact it has never been the norm. The closest it came was a job for most MEN. And even then, full employment of even men required massive wars to soak up a lot of those men. Without the wars, we would never have been even close to employing all the men, let alone the other half of the adult population.

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    6. Ngoc Luan Ho Trieu

      logged in via Facebook

      In reply to David Thompson

      I think John means
      '.."The "desired" unemployment rate is full employment, a job for everybody who wants to work. It used to be the norm"
      I think by 'wants' he means 'actively looking for work.'

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    7. Ted Stead

      Consultant

      In reply to David Thompson

      "Without the wars, we would never have been even close to employing all the men" - not just for the war, but for many, many years atfter: http://www.budget.gov.au/2004-05/bp1/image/bst4-1.gif

      It wasn't until neoliberalism/monetarism/inflation targeting took over from government actively being involved in employment in the mid 70s that "full employment" went from being around a steady 2% to over 5%.

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    8. Ngoc Luan Ho Trieu

      logged in via Facebook

      In reply to Ted Stead

      Very good chart there Ted. I think the oil crisis is partially responsible for that jump in Unemployment data too. That's why I believe that to avoid future wastage of efforts and productive resources of all kinds in the face of such external factor, the gov needs to have strong "green" policies to search for renewable energy sources (solar, wind, biofuels, geo thermal). Obvious benefits are: (i) less economic dependency on foreign oil; (ii) less drain of foreign currencies; (iii) more manageable…

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    9. Ted Stead

      Consultant

      In reply to Ngoc Luan Ho Trieu

      Ngoc, no doubt it was the oil crisis, but what's interesting is that "full employment" since the oil crisis is now much higher than it was before. Obviously there was a change during that time, and coincides with the rise of monetarism/neoliberalism.

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  7. Rob Heck

    Project Manager

    I agree Adam, the 'media induced public opinion' of the masses is that a deficit is catastrophic! Even though most would swing in and out of a deficit of their own while managing a debt, and might argue sound management of their situation.
    I'm not saying our economy is being handled brilliantly, but reports like Mr White's are a good example of the 'other side' of media horror stories.
    I'll put my hand up for any deficit and debt created by a government investing heavily into renewable energies or the alike.
    You've gotta spend money to make money! (as long as its a sound business plan).

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    1. Michael Hay

      retired

      In reply to Rob Heck

      Back in the days when handling one's finances was not contaminated with economists' theories, one would borrow for capital works (building a home, building a railway line) but never for runn9ing costs (paying for school fees, running the railways). There is no sound reason why whole countries should not operate on the same basis.
      Unfortunately the basis for such economic management is common sense, not political belief - and herein lies our current problem.

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    2. John Armour

      logged in via email @bigpond.com

      In reply to Michael Hay

      From a "common sense" point of view Michael there's no functional reason why the government should have to borrow when its spending exceeds taxation.

      If the government is the monopoly issuer of the currency why should it have to borrow from anybody ?

      I think this has been explained by a few others in these threads over the last week or so, but I'll say it again.

      The reason the government issues debt when it deficit spends is so the RBA can mop up excess reserves in the banking system (caused by the spending) and thereby keep control of the overnight cash rate.

      The process has all the appearances of borrowing to spend, and if you can be fooled into also believing that the government's budget is like a household, then it's not hard to push nonsense like "we're living beyond our means".

      I haven't worked out whether certain pollies say such things because they're stupid, or they think I am.

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    3. Michael Hay

      retired

      In reply to John Armour

      arrogance on their part and a distinct lack of respect for voters,John.
      I grant you that any Government can take full control of its currency along with its control of debits and credits. It happened during the reign of the Bretton Woods Agreement, but would take a huge resolve to go back to that level of monetary certainty. I'm afraid that the money traders, the banks, the hedge funds, the fancy accountants have moved so far away from honesty in their dealings that a sound economic basis for the world's economies is not looking good.
      That does not mean to say that honesty is not achievable - just bloody hard work!

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  8. John Kelmar

    Small Business Consultant

    Sounds all "Greek" to me. At least that is what has happened in Greece.

    Governments should lead by example and show the population that proper management of the finances can be achieved by using a number of basic principles - don't spend more than you earn, save a little for the future, and ensure that your savings will generate a reasonable income.

    These rules apply to each and every person as well as businesses, and Governments, but it appears that some business put themselves above the…

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    1. John Armour

      logged in via email @bigpond.com

      In reply to John Kelmar

      Your "basic principles" make perfectly good sense within the constraints of the private sector but they have zero application at the level of the national government.

      You aren't the first here to fall into the "Fallacy of Composition" trap, but it does make me wonder how many times it has to be stated before the message gets through. It's not like it's a new idea...

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    2. Ngoc Luan Ho Trieu

      logged in via Facebook

      In reply to John Kelmar

      Agree with your basic principles which should be adhered to in normal circumstaces of the economy.
      I think there are times when events force responsible govs to go against those principles to some extent to prevent the economy or the country from falling into and abyss and chaos.
      GFC is just one of the examples. Foreign invasions are many other examples in history.

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