Keynesian Spending Does Not Lead To Higher Debt

Keynesian Spending Does Not Lead To Higher Debt
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In the 80 years since Keynes published his General Theory, few questions have been as controversial as whether or not government spending can stimulate a weak economy. New research shows that stimulus spending indeed does work, even for countries facing high debt burdens, unemployment and inflation.

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The research appeared in a paper, Fiscal Stimulus and Fiscal Sustainability, by Alan Auerbach and Yuriy Gorodnichenko, both of the University of California at Berkeley. It was published August 29.

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Their key finding, stated in the paper’s abstract, was that, “For a sample of developed countries, we find that government spending shocks do not lead to persistent increases in debt-to-GDP ratios or costs of borrowing, especially during periods of economic weakness.”

This amounts to a validation of the counter-cyclical measures advocated by John Maynard Keynes in the 1930s as a way to escape from the Great Depression. Those measure have since become a central component of what is known as Keynesian economics.

In earlier work, researchers have found that economies respond more in terms of GDP growth and other measures of economic activity to fiscal stimulus in a weak economy than in a strong economy. Basically, the Keynesian prescription works when you expect it to work – when there is a lot of slack in the economy.

This research goes further to show that fiscal spending in a weak economy does not lead to higher debt levels, higher interest rates or wider CDS spreads. It was the first research to look directly at the effect of spending on the debt-to-GDP ratio.

I spoke to Auerbach on September 12 and we discussed the relevance of his findings to fiscal policies under the Obama and Trump administrations, as well as to other countries. I’ll come back to that later, but, first, let’s look at the research he and Gorodnichenko published.

Does fiscal spending drive up debt?

To look at the effect of fiscal spending on an economy, Auerbach and Gorodnichenko first had to define what they considered to be a fiscal “shock.” The difficulty is isolating those spending measures that are not part of a country’s current policies. Certain spending changes are expected, such as gearing up for a war, but the authors needed to identify those changes that weren’t anticipated.

The conventional way is to do this is credited to Olivier Blanchard and Roberto Perotti, and looks at all observable economic variables and calculates the difference between actual and projected spending. But their method is limited, for example, because it can categorize spending as unanticipated in cases where it was planned, but moved from one period to another. To control for those and other situations, Auerbach and Gorodnichenko used their own approach, which incorporates projections from professional forecasters.

Auerbach and Gorodnichenko looked at how those spending shocks affected a country’s debt-to-GDP ratio, interest rates and credit-default swap (CDS) spreads, in order to determine whether stimulus spending impairs a country’s ability to borrow in the future.

Auerbach and Gorodnichenko looked at the data for weak and strong economies, based on the business cycle (whether an economy was in a recession or expansion) and on the level of unemployment. They defined “weak” and “strong” based on how significantly the variables deviated from their historical trends.

They looked at approximately two dozen large, developed countries using historical data as far back as 1980.

By Robert Huebscher, read the full article here.

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