The 'More is Less' Fantasy of Today's Public Finance

Richard Howard, the global strategist of the hedge fund Hayman Capital, has recently articulated thus one the popular delusions regarding current 'austerity' programs:  

‘At the moment, the peripheral countries are cutting their budgets quickly and aggressively, which is having a negative impact on their economies and making it even harder for them to reach a balanced budget.’(Business Spectator)

There you have it: to cut government spending is to make it harder to balance the budget. And conversely, to increase spending is to reduce the deficit. The might be called the More is Less fantasy. More government spending, less of a deficit.

Let me give this fancy its due: increasing government spending by $1 probably will increase GDP in many contexts; and so will increase government revenue. But will a dollar of spending increase revenue by more than a dollar? Not even the most crude, skewed and one-eyed Keynesian models will allow this conclusion.

To see this, let's travel into a Keynesian universe as far as an unhinged reason will permit.

We may begin  - in the spirit of extreme Keynesianism - by throwing out any suggestion that the economic system has a self-equilibrating tendency, and assuming the most simplistic Keynesian model of the elementary textbooks (often referred to as the 45 degree model). Such a model assumes away the possibility that in response to an increase in government spending, the interest rate might rise (and so reduce investment); or that the exchange rate might appreciate (and so reduce exports); or that the price of output might rise (and so reduce real money balances, with further negative implications for the interest rate and the exchange rate); or that consumers will perceive that any extra government debt spells future interest charges and future taxes to match; or that consumers will save almost all of any temporary increase in income that might be generated by a temporary increase in government spending.

In other words, we give everything we can to the Keynesian model. And we now give more. We suppose that there is zero 'leakage' arising from savings: that is, 100% of any extra income is consumed by households. And we assume zero leakage arising from imports: that is, 0% of any extra income is spent by households on overseas sourced goods and services.

This is the model of the ultimate 'multiplier'. In such a model if the government spends another dollar (financed by debt) then that will generate 1/t dollars of extra GDP, where t = the fraction of an extra $ of GDP that will flow to the government in higher taxes.

So what is the extra revenue from this extra GDP? Some simple algebra gives us the answer:

t * 1/t  

And  t * 1/t  equals 1.

Thus in this ultimate multiplier model one extra dollar in government spending will generate one extra dollar in revenue, exactly.

The consequence is that the slightest movement away from the 'ultra' assumptions made above implies that one extra dollar in government spending will generate less than one extra dollar in revenue

So if we allow households to save even just a few cents of extra $ of income then the multiplier will be smaller than 1/t, and so one extra dollar in government spending will generate less than one extra dollar in revenues.

And if we allow households to spend even a few cents of extra income on imports, then the multiplier will be smaller than 1/t, and so one extra dollar in government spending will generate less than one extra dollar in revenues.

Conclusion: even in this extreme Keynesian universe, More is, alas, More. And Less is Less: less government spending, less deficit.