More, Not Less Government

           The federal government’s largest expenditures are on insurance and defense. Through Social Security, Medicare, and Medicaid, the federal government takes care of the sick and poor old. Through the Departments of Defense, State, and Homeland security the people of the United States are protected from outside threats. So much of what people would like to remove for their own ideological ends are rather incidental when it comes to the overall budget. Some on the right are not fans of the Federal Reserve or the Departments of Education and Energy. Some on the left would see the Defense Department or the various law enforcement agencies shelved.

            One problem is that politically, none of the agencies will be closed even if a large number of people wanted them to be. There are so many incumbents who will rise to protect their own turf and justify their position’s existence, even if there are duplications over what they do and another person does – and they both draw paychecks from the federal government. The other problem is that some point along the line there were debates on certain expenditures that were justified at the time and the expenditures were voted on through our democratic process, no matter how messy it is. So we have the government in the citizen’s lives in so many ways that the government is just part of the air to be breathe instead of an intrusion – see the worries about the government involvement in health care and the old woman wanting the government to take their hands off their Medicare.

            This is important, because even though looking at the budget and wanting to strike through different line items, it illustrates an important point. The government is not some separate foreign body, but the government at the federal level is the agent of the people as a whole. The government is the collective will of the people. By banding together, government leverages the money and the abilities of the collective to build roads and to defeat Hitler. That is not to say that sometimes the leaders of the government forget that they are serving at the will of the people and not at their own will. Fewer bullets should be bought for the soldiers and fewer soldiers should draw paychecks, but the people need protection and to say otherwise would be utopian dreaming.

            The debate is what levels of spending should there be and where to prioritize that spending. Could the federal government spend less on defense and keep us safe? Most likely it could be. The real question is where the government is failing to provide goods where it could be the most efficient provider. The most obvious is in education. Most schools for primary and secondary levels are funded at the local level. Tertiary education had been funded largely at the state level with assistance from the federal government in terms of subsidized loans and direct grants. The issue is that the federal government uses these loans not as a cost center, but receives income from them when their rates are greater than what the government can borrow for.  The current state is that the cost of education is born by the individual. The problem is that it lowers spending on goods and services and prevents household formation. If the federal government would instead fund education directly, youth would have a better start to their lives instead of worrying about an overhang of debt. By investing in human capital, the government could make the country better down the line by making it more productive and more capable. This could come from all new spending or it could come from cost shifting in a shifting of some priorities.

Overall, there is no one place the federal government needs cut. Government is good, and there is not enough of it.

The Keynesian Cross

The figure below shows a simplified representation of an economy with a fixed price level, no government, no net exports, and a fixed interest rate. The simplification is done to illustrate the relationship between consumption and business spending in investment. At all points on the blue line, aggregate expenditure equals the planned aggregate expenditure that in this model equals GDP. The red line is the planned aggregate spending, represented by the consumption function (fixed spending plus the marginal propensity to spend times free cash). It is a line with a slop that is the MPC with a non-zero Y-intercept that is the fixed spending plus planned investment (Krugman & Wells p. 330).

Figure 3 adapted from Krugman & Wells p. 330

            These two lines only intersect at point E, and the spending at point E is known as Y* or the “income-expenditure equilibrium GDP”. At all other levels of real GDP, there will be an adjustment that businesses have to make. They will have to adjust their investment with an unplanned component. This unplanned component can be positive or negative, as represented on the graph by letters A and B on the x-axis.

            At point A, the level of planned business investment is greater than the 45-degree line, or real GDP. This will cause the unplanned component to be negative, and it will force real GDP to rise, as businesses have to replenish their inventories. Conversely, at point B, the level of planned business investment is below the 45-degree line, meaning the unplanned component of business spending is positive. Businesses are creating a surplus. In both situations, there will be a move towards equilibrium. If the economy is at point A, then businesses will have to replenish their inventories and that will grow the real GDP. If the economy is at point B, then the economy will have to slow down, lowering the level of real GDP as it moved back to point E, where the aggregate spending and the GDP are the same (Krugman & Wells p. 330).

Plugging the Inflationary Gap

The figure below represents an economy that has grown so quickly that the aggregate demand has been pushed to the right, beyond the long run aggregate supply curve. AD₁ represents the current state of the economy. It intersects with the short run aggregate supply curve at E₁. The intersection means that the overall price level has increased from what would be it is equilibrium level where the aggregate demand, the long run aggregate supply and the short run aggregate supply curve would all intersect at point E₂.

Figure 2 adapted from Krugman & Wells, p. 381

            The current equilibrium has raised the price level so that the economy is undergoing a period of inflation. To move the economy from the equilibrium from the point E₁ to E₂, the government in charge of this economy needs to undergo some contractionary fiscal policy to move the aggregate demand curve from AD₁ to AD₂, making the equilibrium point meet the line of potential output instead of outpacing it.  There are several options that this government has to enact its contractionary fiscal policy. One option is to decrease the amount of direct government purchases of goods and services. Another option is to increase taxes so that consumers have less money to spend. A second way to limit money in consumer hands would be to decrease the amount of transfers the government sends to consumers (Krugman & Wells p. 381).

            All three options would have the effect of lowering the aggregate demand so that the economy would be able to cool off and the period of inflation would dissipate, moving the aggregate demand curve to the point where the equilibrium point is on both on the short run and the long run aggregate supply curves.  

How to Grow the Economy

If the government wants to expand the economy, it could go about doing it multiple ways. It could cut taxes, so that consumers have more money in their pockets. The government can also send money to people in the form of checks as transfer payments. Both of these can be good politics as they can be spun to show that the government is trying to shrink itself and to not spend the people’s money wildly. Both of these can trouble because of the marginal propensity to spend. If people save that new money instead of going out to the store and spending it, that money is wasted in terms of trying to grow the economy. Money not spent does not show up in the GDP calculation (Krugman & Wells p. 386).

            However, there is a more effective way to grow the economy. If the government instead spends the money on good and services, the same money is out in the economy. There is still the fact that the money will get pushed on through to consumers, who will then spend only a fraction of that money and the government has to be cognizant of the marginal propensity to consume. Growing the size of the GDP directly through growing the G section of the GDP equation is much stronger than just giving people money. Not only does the government get money out into the economy, but the nation also gets a new bridge or jet fighter or whatever it is the government bought.

There are bound to be limits to this sort of growth.  For example, there is a lag time to new acquisitions. When the stimulus package was passed in the wake of the economic crisis of 2008, many of the infrastructure projects took time to get off the ground and there was much political hay made over the idea of “shovel ready projects”. Just sending checks to people is much faster, but then there are fewer jet fighters or state-of-the-art bridges. Overall, the lag time is a fair trade off as long as the MPC is below one.

Finally, there is a further concern that there are only so many bridges that can be built or improved. Once the nation is in a post-scarcity gleaming futuristic utopia then the direct government expenditure approach might not be the most effective avenue for growth, but the nation is far from that point for now.

Automatic Stabilizer

An example of an automatic stabilizer would be the issuance of unemployment insurance. When the economy is in an expansionary phase, the government has to pay fewer claims of unemployment. When the economy is contracting, then the government has to pay more unemployment claims. This is an automatic stabilizer because it helps moderate the business cycle. Money is pulled out of the system by having fewer transfers when the economy is in expansion. Conversely, recessions are not as bad because unemployment benefits are spend in the economy, boosting consumer expenditures (Krugman & Wells p. 388).

            Figure 1 below is a representation of two different economies growing on the same track. The blue line is the economy that does not have automatic stabilizers in place. Its growth is more erratic, the peak is higher, but the trough is also deeper in comparison to the peak. The economy represented by the orange line is one that has automatic stabilizers in place, like unemployment insurance. The path is moderated so that the peaks are lower, but the trough is also not as deep as the one in the blue economy.

Fig One