September 14, 2011
Government finances are like...
By Cindy Ivanac-Lillig
In speaking about the financial crisis and how it is different than other types of crises, I have often invoked the metaphor of the human body. Banking may be like the circulatory system in our body. The organs may all be in great shape but if blood isn't flowing, everything suffers.
Similarly, many have invoked the metaphor of the household when speaking about the government and its finances. The government should behave like any responsible household. If a household has to live within its means, than why shouldn't the government? The problem with this is that although it is simple and memorable, it is not instructive. When a household spends less given the same level of income, it has improved its financial situation. When the government spends less in our current economic environment, it may mean that it will take in less income as well. Government spending increases the purchases of goods and services (economic activity), which increases tax revenue. Government finances are more like a dynamic function of both tax policy and the general health of the economy and less like a simple budget model from personal finance. There is balance of long term and short-term changes the government can make to improve the overall dynamic, but unfortunately this doesn't lend itself to a simple and memorable metaphor.
What do you think -- do you have any ideas? Government finances are like.....
Posted by Cindy at September 14, 2011 3:57 PM
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At the very least, this only applies when there are slack resources in the economy. Otherwise your prescription is like a perpetual motion machine where government can spend more and GDP will rise. At full employment increase in G has to mean a decrease in consumption or investment. Or run a deficit by borrowing from abroad. Which we'll have to pay back in the future. That form of investment may be wise, but for households, too, it's sometimes wise to borrow.
Posted by: John B. Chilton at September 14, 2011 10:35 PM
Excellent! The government-household budget analogy is one of the most wrong-headed and damaging ideas that I (as an Economics Professor) must unwind each semester. I use imagery to try to demonstrate that the private sector's financial position actually improves when the public sector's deficit increases. Check out the teeter-totter analogy I used to show what happens when the government tightens its belt: http://neweconomicperspectives.blogspot.com/2011/06/what-happens-when-government-tightens.html
Posted by: Stephanie Kelton at September 14, 2011 10:40 PM
In the same vein as your analogy (no pun intended) government finances are like a fluid system. Say, household plumbing. Government purchases and taxes serve to regulate aggregate demand, just as valves increase or decrease the rate at which water flows from the faucet. Taxes remove purchasing power from the economy while government spending adds to it. One is a leakage the other an injection.
Now, if we have a kitchen sink we can think of taxes as the drain and government purchases as the faucet. When governments run deficits, they will fill the sink faster than it will drain. Depending on the available capacity of the sink this may pose a problem, as the sink may overflow. Of course, if we keep our analogy tight, as the sink reaches the brim negative feedbacks engage and the faucet is constricted while the drain opens.
But, then at other times it may be the case that there are other leakages in the sink besides the drain, causing the sink to drain faster than we would otherwise expect. This is the point at which we crank the faucet as wide open as we can get it, and maybe pull in a house from outside.
Leaks are to sinks as cash hoarding is to the economy. So, with as many politicians and economists sticking to the household budget analogy, perhaps we ought to consult a plumber to close the output gap.
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