For most experts a key factor that policy makers should be watching is the gap between the actual real output and the potential real output. The potential output is the maximum output that the economy could attain if all the resources are used efficiently.
The gap is labeled as the output gap. In June this year the output gap - expressed in percentage terms - stood at 3.8% against 3.25% in March and 2.75% in June last year.
A strong positive output gap can be of concern because according to experts it can set in motion inflationary pressures. To prevent the possible escalation of inflation, experts tend to recommend tighter monetary and fiscal policies.
Their preferential outcome would be to soften the aggregate demand, which is considered as the key driving factor behind the positive output gap.
However, of greater concern to most experts is a negative output gap, which is associated with a severe recession.
The output gap was in the negative area between November 2008 and June 2013. Note that in June 2009 it had plunged to minus 3.34% (see chart).
Most commentators are of the view that with the emergence of a negative output gap the most effective policy to erase this gap is aggressive fiscal stimulus i.e. the lowering of taxes and increasing government outlays - a policy of large government deficit.
This way of thinking follows the ideas of John Maynard Keynes.
Briefly, Keynes held that one could not have complete trust in a market economy, which is inherently unstable. If left free the market economy could lead to self-destruction.
Hence, there is the need for governments and central banks to manage the economy.
Successful management in the Keynesian framework can be achieved by influencing the overall spending in an economy.
It is spending that generates income. Spending by one individual becomes income for another individual according to the Keynesian framework of thinking.
What ultimately drives the economy then is spending. If during a recession consumers fail to spend then it is the role of the government to step in and boost overall spending in order to grow the economy.
If for whatever reasons the demand for the produced goods is not strong enough this leads to an economic slump. (Inadequate demand for goods leads to only a partial use of existent labour and capital goods).
In this framework then, it makes a lot of sense to boost government spending in order to strengthen demand and eliminate the economic slump.
Without funding, no increase in demand is possible
What is missing in the above is the subject matter of funding. For instance, a baker produces ten loaves of bread out of which he consumes two loaves and exchanges eight loaves for a pair of shoes with a shoemaker. In this example, the baker funds the purchase of shoes by means of the eight saved loaves of bread.
Note that the bread maintains the shoemaker’s life and wellbeing. Likewise, the shoemaker has funded the purchase of bread by means of shoes that maintains the baker’s life and wellbeing.
Consider the event that the baker decides to build another oven in order to increase the production of bread. In order to implement his plan the baker hires the services of the oven maker.
He pays the oven maker with some of the bread he is producing.
What we have here is a situation where the building of the oven is funded by the production of a final consumer good: bread.
If for whatever reasons the flow of bread production is disrupted the baker would not be able to pay the oven maker. As a result, the making of the oven would have to be aborted.
From this simple example, we can infer that what matters for economic growth is not just the existing stock of tools and machinery and the pool of labor, but the adequate flow of final goods and services that maintains individual’s life and wellbeing.
Now, even if we were to accept the Keynesian framework that the potential output is above the actual output, it does not follow that the increase in government outlays will lead to an increase in the economy’s actual output.
It is not possible to lift overall production without the necessary support from final goods and services or from the flow of real funding or the flow of real savings.
We have seen that by means of a final consumer good – the bread – the baker was able to fund the expansion of his production structure.
Similarly other producers must have final saved real consumer goods – real savings – to fund the purchase of goods and services they require.
Note that the introduction of money does not alter the essence of what funding is. Money is just a medium of exchange. It is only used to facilitate the flow of goods it however cannot replace the final consumer goods.
Fiscal stimulus and economic growth
Since the government is not a wealth generating entity, how can an increase in government outlays revive the economy?
Various individuals who will be employed by the government will expect compensation for their work. Note that the government can pay these individuals by taxing others who are still generating real wealth. By doing this, the government weakens the wealth-generating process and undermines prospects for economic recovery. (We ignore here borrowings from foreigners).
Now, fiscal stimulus could “work” if the flow of real savings (i.e., real funding) is large enough to fund government activities while still permitting a positive growth rate in the activities of the private sector. (Note that the overall increase in real economic activity is in this case erroneously attributed to the government's loose fiscal policy).
If, however, the flow of real savings is declining, then regardless of any increase in government outlays, overall real economic activity cannot be revived. In this case the more government spends i.e. the more it takes from wealth generators, the more it weakens prospects for a recovery.
Thus when government by means of taxes diverts bread to its own activities the baker will have less bread at his disposal. Consequently, the baker will not be able to secure the services of the oven maker. As a result, it will not be possible to boost the production of bread, all other things being equal.
As the pace of government spending increases a situation could emerge that the baker will not have enough bread to even maintain the workability of the existing oven. (The baker will not have enough bread to pay for the services of a technician to maintain the existing oven). Consequently, his production of bread will actually decline.
Similarly, as a result of the increase in government outlays other wealth generators will have less real funding at their disposal. This in turn will hamper the production of their goods and services and in turn will retard and not promote overall real economic growth.
As one can see, the increase in government outlays leads to the weakening in the process of wealth generation in general.
According to Ludwig von Mises in Human Action,
…there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of it quantity.
