Magic disappearing money and arguments against fiscal policy

Government budget surpluses result can result in the penury of the private sector, according to a media piece this week. But this argument against surpluses can easily be transformed into an argument against deficits.

The article provides a simplified example. A government surplus of $5 means the wealth of the private sector goes down from $100 to $95. The article goes on to say:

Imagine the government continues with the same budget the following year. The non-government sector now has $90 – and the year after $85.

Each year, the government would tax $5 more than it spends. What would it do with the surplus? While the article doesn’t make it clear, we could safely assume that the government would lend that $5 back to the private sector. After many surplus years, tax would consume all of the private sector and the Future Fund would grow to own everything. Socialism at last!

This argument against surpluses has a lot going for it: taxes are a transfer of wealth to the government after all. We are made worse off by taxes being too high. But the media piece — unsurprisingly — reaches the wrong conclusion: deficits are better than surpluses.

However, the argument can run in both directions: the argument against surpluses can be used to argue against deficits. A surplus means the government ends up with excess funds that it then lends to the private sector. Conversely, a deficit means the government has to borrow from the private sector. This means that businesses and households either cut back on consumption (i.e. living standards) or investment. Maybe not a worthwhile cost to pay.

Or another way of looking at it: if the government spends more than it saves, then the rest of the economy has to save more than it spends.

Regardless, neither deficits nor surpluses directly change the total amount of money in the economy, they just rearrange it. And this is supported by evidence that that public sector savings and private sector savings move in opposite directions.

By now this argument may appear vaguely familiar. Well, yes it is. This is a key argument in favour of Ricardian equivalence, which states that government deficits and surpluses are fully offset by private sector actions, and don’t have a direct effect on the economy.

The conclusion of this train of thought is that government stimulus (such as during the GFC) has no beneficial effect at all. Probably not a popular argument in on the left.

But don’t hold your breath for this argument to be pushed too hard.

Michael Potter is a research fellow in the economics program at the Centre for Independent Studies