Question

Some economists, such as Paul Krugman, argue for government to take a more Keynesian approach to promoting economic growth—that government borrowing can be economically healthy, in developing infrastructure for future needs or to spend its way out of a recession. More conservative economists argue that a country’s economic growth over the long term is better obtained through a tighter monetary policy and a more aggressive approach to balancing the budget. Which is more important for a healthy economy, a balanced budget or avoiding recession? Are increased deficits okay as long as they are stable relative to our gross domestic product?

Answer 1

As an overview, the economy consist of the private sector, the household sector and the government sector. It is important to note that the government sector is a relatively static sector of the economy. On the other hand, the private sector and the household sector are the dynamic sectors (growth triggering sectors) of the economy. With this overview, any action that negatively impacts the private and household sector is negative for the economy.

Coming to the specifics, the financial crisis of 2008-09 underscored the importance of government intervention in the economy. When the economy is in recession, it is important for the government to expand spending so that the economy recovers through higher spending. At the same time, the government can lower taxes and as disposable income increases for consumers, it triggers consumption spending in the economy. Higher government spending and lowering of taxes increases the budget deficits and federal debt. However, this is a necessity during times of recession and slowdown.

At the same time, when the economy is witnessing healthy growth, the government spending should decline and taxes should trend higher. In other words, the deficits created during recession can be potentially balanced by higher taxes and lower government spending during economic boom.

The key concern is when government spending and budget deficits sustain during economic booms. Just as an example, the budget deficits in the United States have been widening even as economic growth remains healthy. The concern in this scenario is that the budget deficits need to be covered with government borrowing. As the government borrows, the availability of loanable funds for the private sector declines and interest rates trend higher. This reduces private sector investments in the economy and is referred to as "crowing out." Since the private sector is the dynamic sector, it is negative for economic growth.

At the same time, as government debt continues to swell on a sustained basis, it is very likely that taxation will increase at some point of time or the government will try to create enough inflation to make the debt look smaller. Be it higher taxation or inflation, it is negative for consumers and businesses.

Therefore, the bottom-line is that the government needs to swiftly limit its role to oversight during economic booms. This will help in reducing deficits. If government deficits sustain during booms as well as recessions, it is negative for the dynamic sectors of the economy.