More on the mysteries of public finance

Feb 13, 2006

Despite the very large surplus budget at the Federal level the talk has once again turned to deficits and the supposed threat they pose to Canadian well being. It is quite simply amazing that so many people still believe despite unemployment close to a full 2 % points above a reasonable target level for relatively full employment, unmet needs in infrastructure and capital investments, unmet needs in
social, health and educational investments, that deficits, even temporary ones are unacceptable.

Alvin Hansen was a leading economist at Harvard University and the author of numerous texts. Along with Joseph Schumpeter he was the most famous economist in America during the 1930s, 40s and fifties.

He advised Roosevelt, knew Keynes, helped bring about the Keynesian Revolution in economic policy. His writings on issues of public debt make for very interesting reading today.

In his excellent work "Fiscal policy and business cycles" he points out that deficits and debts are essential tools in fighting the business cycle and ensuring prosperity in a capitalist society whenever there are slumps in economic activity due to depressed investments by the business community or collapses in consumer spending or neglected capital infrastructure.

He puts it as follows`The attack on chronic unemployment by public debt expenditures financed by a continuously rising debt is essentially a conservative proposal....(understood in its proper context)` " A public debt, internally held, is not like a private debt. It has none of the essential earmarks
of a private debt. The public debt is an instrument of public policy. It is a means to control the national income and, in conjunction with the tax structure, to regulate the distribution of income." (p.89)

Hansen explains that the debt can be financed in three different ways.Either by borrowing the money from savers who purchase the bonds issued by the Government. In this way high quality debt instruments are supplied to the money markets at a time when because of the depression or slow down there is a dearth of comparable high quality private instruments; the debt can be financed by an increase in high powered money at the central bank which contrary to conventional wisdom is not inflationary because the problem at the moment is not inflation but depressed aggregate demand or it can be financed and thereby eliminated by tax increases.

The last of these approaches is not a good idea when the economy is suffering economic depression. Increasing taxes will subtract private economic demand and deepen the depression. The other two approaches in some combination is a more ideal solution. Of course, there is much hysteria about increasing high powered money but whenever the central bank buys securities in the open market in an effort to lower interest rates it is expanding the base of high powered money. Once the economy has recovered the central bank can sell securities to shrink the base thereby gradually raising rates to slow the expansion to a sustainable pace. Hansen discusses the economic history of debt finance in detail. In particular he examines the career of Alexander Hamilton who argued that the debt in certain circumstances   was a national blessing that would permit, if the policy were a balanced one, the economic growth of the United States.

Hansen rejected the claim made by critics of deficit   finance that increasing public debt would lead automatically to inflation.It is useful to quote him at length.

"This conclusion is not justified. No general statement can be made without an examination of the special circumstances in each case. The deficit may be financed by: a) borrowing from the banks, b) borrowing from accumulated idle balances held by corporations and individuals, and c) borrowing from the current income of the individuals and corporations. The first method of financing results in an expansion of the money supply(demand deposits); the second results in an increase in the velocity of circulation. Whether new money
is created or idle money is put to active use , in either case the income stream MV is increased.But this process will not cause a price inflation as long as it is possible to match the increasing stream of money income with a corresponding increase in the flow of real income. In short, as long as there are unemployed resources neither of these methods of financing a deficit constitutes a dangerous threat to price stability. " (p.171)

Nowadays we would have to point out that prices can begin to rise well before all unemployment is eliminated . This is so because of the heterogenous nature of factors of production and industries. But the fact that this occurs at unemployment rates of about 4-5 % still gives us considerable room to do much better than we have been doing.
Also Canada's internal financial markets need to be further deepened and widened so as to reduce the temptation to finance our debts disproportionately on international money markets. But for the moment this is not a problem for federal debt. The total value of these debt instruments held abroad is around 24 %.

Finally any conversion to a more Keynes/Hansen/Lerner style of functional finance would have to be done gradually over time. For the moment it is not even an issue as the federal government is running large surplus budgets.
Our priority ought to be to reduce unemployment toward the 4-5 % range, allow the debt to GDP ratio to shrink gradually below the 35 % mark still establishing Canada as one of the leading G8 countries with respect to a shrinking debt burden and continue to finance capital investments in health care, infrastructure, education and social policy. None of these add to dead weight debt. Instead they increase productivity, national wealth and rates of economic growth.