Download Expanding or Curtailing Government Spending

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Towards Promoting Economic Growth:
Expanding or Curtailing Government Spending
Growth of the GDP (Gross Domestic Product) is the objective of every economy in the world. A higher rate of growth
means a larger “pie,” consisting of all goods and services generated in the economy, resulting in increased employment
and income. If the rate of growth of the GDP (the pie), is higher than the growth of the population, then the GDP per
person grows to the benefit of all dividing the pie, explains Dr. Irit Malka, coordinator of the MBA course in International
Monetary Economics. A larger slice of goods and services means greater benefit to all the individuals who are part of
the economy, and, thus, to the overall well-being of the economy itself. But how is this growth to be achieved? What is
the role of government spending in promoting growth?
The Case for Increasing
Government Spending
Anyone who studied macroeconomics, even an introductory
course, is familiar with the Keynesian
Model, which indicates that during
recession, a policy of budgetary
expansion should be taken to increase
the aggregate demand in the economy
thus bolstering the GDP, explains Dr.
Malka. Increase in local government
spending translates into increased
employment in the public sector and
increased orders of products from
suppliers and firms in the business
sector. In other words, employment
rises, income and profits of suppliers
and firms increase, and they, too,
can hire more employees to
produce the goods and services
ordered by the government. The
unemployed, who have now
found work, whether in the
public sector or the business
sector, enjoy an increase in
income, and their demand and
purchase of products increase.
Larger profits also increase the
purchasing power of firm owners
and suppliers and the overall
growth results in an increased
demand for goods and
investments.
According to the Keynesian model, if
demand increases, business concerns
produce more merchandise and
services, and the result is a substantial
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increase in the GDP, far more than the
increase in government spending,
explains Dr. Malka. Budgetary
expansion acts as a catalyst to increase
demand and production within sectors
that do not have direct contact with
public demand.
The Problem with Increased
Government Spending
If this remedy for recession is effective,
sweet and has no side-effects, why do
so many oppose a policy of budgetary
expansion? Firstly, a large public
sector diminishes the business sector
in personnel and in sources of
investment. It may be maintained that
in times of recession, much of the work
force is not employed at all, and
therefore, employment in the public
sector does not come at the expense of
the private sector. Furthermore, in a
burgeoning economy, government
spending can be curtailed, the
If this remedy for
recession is effective,
sweet and has no sideeffects, why do so many
oppose a policy of
budgetary expansion?
government sector can revert to a lower
level of spending and personnel can be
re-directed to the business sector.
However, while budgetary expansion
is easy in a recession, cut-backs during
economic highs are very
difficult. No minister or director
of a public institution
relinquishes control, authority
and budgets easily, says Dr.
Malka. The result is an inflated
and inefficient public sector
even after the recession is over,
and a lower rate of growth in the
private sector than its potential
would indicate.
Noteworthy is the efficiency of
the private sector, particularly
compared to the government
sector. A public organization can
continue its activity even if the services
it provides are no longer required. Its
directors and the relevant minister will
not be quick to relinquish power which
is a function of the jobs they control
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and the funds at their disposal. The
result is superfluous services, wasting
personnel and capital, which could be
directed to production that provides
well-being and benefit to individuals
in the economy. On the other hand, a
but research has shown its negative
effects in many cases. The essential
problem of inflationary factors is
uncertainty regarding future prices,
difficulty of planning production lines,
purchase of raw materials and products
and sales. In other words, the damage
is to the stability and scope of
production and its components,
and this is counter-productive
to the objectives of growth
of the GDP, explains Dr.
Malka.
Exaggerated government
deficit could undermine
the stability of the
economy and cause
deterioration rather than
growth.
private firm, whose product is no
longer in demand will close. Lack of
demand means lack of income, and
losses result in closing. If a product is
not of benefit, resources will not be
wasted on it.
During a recession, personal income
and profits of firms decrease and result
in decreased tax revenues. Thus
governments, if they wish to maintain
their current level of activity, have to
create a deficit. This compounds the
complexity of increasing government
spending. Exaggerated government
deficit could undermine the stability of
the economy and cause deterioration
rather than growth. Financing the
deficit is accomplished by a public loan
or a loan from the central bank. A
central bank loan means an influx of
money in the economy which can
have an inflationary effect.
Inflationary damage is not
necessarily felt,
A public loan involves issuing public
bonds, locally or abroad. If loans to the
government from the public exceed the
redemption
of
longstanding
government bonds, the government
debt increases and the credibility of the
government and its ability to return its
loans is diminished. Private and public
institutions (pension funds, insurance
companies etc) will only purchase such
bonds if they yield a high enough return
to compensate for the risk involved in
their purchase. The return on bonds
reflects upon the entire interest rate of
the economy, as was the case in Israel
in 2002, when an increase in interest
rates on government bonds raised the
interest rates in the economy. In every
country, government bonds are the
safest financial asset, and if they
become risky, then the financial assets
of the business sector become even
more risky. Risky economies deter
foreign investment, even if interest
rates are high, and, under those
circumstances, even the local
population tries to invest abroad and
not locally. High local interest rates
result in a decrease in investments and
are detrimental to the GDP.
The Case of Budgetary
Cutbacks
The European Union requires
of its members and of those
who wish to join the European
Union to maintain a budgetary deficit
that does not exceed 3% of its GDP.
This requirement was dictated in the
1990s by Germany, acting to prevent
the negative processes outlined above.
Germany also correctly suspected that
budgetary expansion of some of the
member countries could damage those
members who maintained budgetary
restrictions, like Germany itself. But
since 2002, Germany and France have
both exceeded the permitted deficit,
and Germany is the country being
chastised by the other EU members to
maintain control. Germany is presently
undergoing a deep depression which
has diminished revenues from taxes,
while government spending has
increased. But Germany is unwilling
to revert to budgetary cut-backs in
2004, despite the risks that a deficit can
cause, fearing that government
restriction will further exacerbate the
depression.
Governments the world over are
grappling with these issues, further
complicated by global influences, the
worldwide effects of local economic
decisions, and the events and political
considerations whose impact can be
felt in far-reaching quarters. There are
no magic formulas to achieving
growth, concludes Dr. Malka. She
recommends a policy of preventing
government budget deficits, while
placing emphasis on shifting the
funding to those elements that will
bolster the economy.
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