Govt spending and the economy

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Economic ideology, not hard evidence fuels debate over govt role

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Last of two parts

The impact of government spending on the economy is a subject for intense debate among competing schools of thought in economics. Governments and most analysts take the Keynesian point of view that government spending has a significant positive effect. This is disputed, however, by the classical liberalist point of view defended by Austrian economist Friedrich Hayek (a perspective known as the “Austrian school” of economic thought) that increasing government spending actually retards growth.

The reason the debate continues along ideological lines is that, as was discussed in Part One of this analysis, the best data and methodology for solving the question with hard evidence unavoidably requires too many assumptions. The latest economic input-output table, for example, was published in 2006, and whether the economic relations among the 240 individual sectors it covers are still the same now is uncertain.

A 1998 study recently cited to support the argument for reducing government spending—and conversely, increasing privatization—found that above a threshold of about 15 percent for the proportion of government spending to GDP, increasing that proportion by 10 percent would result in a one percent drop in GDP growth. In addition, a 10 percent increase in the ratio of spending to GDP was found to reduce private investment by 1.6 percent.

The case against spending
The study (“The scope of government and the wealth of nations,” by James Gwartney, Randall Holcombe, and Robert Lawson) covered the OECD nations and concluded that beyond the spending required for “core functions” of the government, government spending had a negative relationship with GDP growth. The estimate of a 15 percent spending-to-GDP ratio as a threshold above which additional spending would have a negative effect represents the highest percentage for that ratio among the 23 economies studied.

What the study identifies is a correlation; it does not necessarily answer the basic question of whether growth follows spending (the Keynesian view) or vice versa. And there is a high degree of subjective judgment involved in the analysis, which the authors acknowledge in an indirect way by describing their definition of “core government functions” as “generous.”

Even giving the accuracy of the categorization of expenditures the benefit of the doubt, there is no certainty the same parameters could be applied to non-OECD economies; a recent (December 15) Forbes article citing the study as evidence supporting a “shrinking government” perspective even acknowledged that by pointing out differences in spending profiles between the advanced economies in the study and the rest of the world.

Another recent study, published in 2009 in the European Journal of Economic and Political Studies, suggests those differences matter enough to at least cast doubt on the generality of the “spending follows growth” perspective. The study compared Nigeria’s government spending and national income between 1970 and 2005, and found a clear correlation between higher spending and income growth, although the degree could vary according to application.

Not ‘how much’, but ‘what’
PIDS’ Dr. Ramon Albert agreed that the application of government spending rather than its magnitude is probably a stronger determinant of what effect increasing government spending would have on the wider economy. “What they spend on would certainly matter,” Albert said, giving as an example the findings of a 1960s-era study (“An Inter-Industry Study of the 1961 Philippine Economy,” by Tito Mijares and Vicente Valdepeñas) which suggested that every peso spent on housing had a multiplier effect of two times.

“The economy, however, has changed considerably since then,” Albert added, “Clearly, infrastructure spending has a big effect, so the plan to slowly increase spending rates to that of our neighbors is a step in the right direction.”

However, the effects of some investments, such as the sometimes controversial Conditional Cash Transfer (CCT) program, might not be felt for years to come. “I daresay that [the government’s]investments in the CCT to help high school student beneficiaries will also have its effects, but these will be measured only about five years from now when these children join the labor market with better educational attainments, as has been the case in South America,” Albert explained.

Whether that happens or not is something that will only be known in hindsight, which obviously presents a challenge for policymakers who do not have very effective predictive tools at their disposal. Inevitably there must be a considerable amount of judgment applied to government spending decisions, something that most observers would agree has had mixed results.

“In the long run, it is really the private sector that should take the lead in investments,” Albert concluded. “That will make the economy’s growth sustainable.”

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