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

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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