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Budgetary Rules and Norms Matter

Matthew Lau and I each contributed an original essay to a Fraser Institute project on deficit spending.

Here’s a direct link to Matthew’s essay, and here’s a direct link to my essay.

And here’s a slice from my essay:

Most of the debate surrounding Keynesian economics focuses on technical or theoretical questions. For example: How sticky are wages? Does government spending crowd out private spending? Is there really a tradeoff between inflation and unemployment?

But in their 1977 book, [James] Buchanan and [Richard] Wagner took a different tack. They argued that even if Keynesian theory is correct, the guidance that it offers for public policy is politically naïve. While politicians will—as Keynesianism counsels—eagerly borrow and spend during periods of unemployment, politicians will stubbornly not follow Keynesian policy prescriptions during times of full employment or inflation. During times that call for tight fiscal policy, no less than during times of unemployment, politicians will engage in debt-financed spending. The reason is that spending more today without simultaneously raising taxes is nearly always a good strategy for winning votes, for it allows citizen-taxpayers today to consume government programs today that will be paid for by future generations. As Buchanan and Wagner summarize, “the Keynesian theory of economic policy produces inherent biases when applied within the institutions of political democracy” (1977: Preface).

Buchanan’s and Wagner’s criticism of Keynes went still further. Keynes and his disciples, argued Buchanan and Wagner, undermined the moral aversion to debt-financed spending not only by actively encouraging such spending whenever a case can be made that aggregate demand is too low, but Keynesians also rejected the long-standing view of economists that debt-financed spending is paid for by future generations. Keynesians rejected this view by insisting that government debt that is “owed to ourselves” is no burden on future generations.

The Keynesian argument regarding debt that “we owe to ourselves” is that the losses to the citizen-taxpayers who must pay the bondholders are offset by the gains received by the bondholding citizens. Voila! Debt creates no net burden on future generations! But this argument, whatever its other flaws, ignores the fact that debt financing nevertheless allows some people (namely, today’s citizen-taxpayers) to spend money belonging to other people (namely, tomorrow’s citizen-taxpayers). And thus debt financing encourages excessive government spending.

But no matter. Widespread acceptance of this Keynesian argument conveyed the false impression that debt financing imposes no burden on future generations. Thus today’s citizen-taxpayers are relieved of qualms they once suffered about government spending borrowed funds. The resulting explosion of government’s net indebtedness, both in Canada and in the US, was no surprise to Buchanan, but it was a source of great worry. That worry now seems justified.