Lee-Roy Chetty
Lee-Roy Chetty

The importance of public spending

The existence of long-term growth effects from public spending is hardly contested in policy discussions.

Growth literature that has emerged over the last 20 years supports the belief that public spending affects long-term growth.

First, standard growth models explaining total output level as a function of factor inputs (capital and labour), as well as the productivity through which these inputs are combined, have been extended by incorporating various elements of fiscal policy.

In particular, growth models assume that governments can raise taxes to finance various types of public expenditures that raise the marginal product of factor inputs in the output production process. This may, for instance, be motivated by the fact that private equipment, such as machinery and vehicles, can be employed more productively when public infrastructure is in place.

Other models embody additional transmission channels through which public spending affects aggregate private investment.

In neo-classical models, there are effects on growth only for a transitional period, as the economy moves to its new level of output — though the length of this transition remains subject to debate and may last a long time.

In addition, empirical evidence increasingly suggests that, in both developed and developing countries, fiscal policy affects long-term growth.

Finally, there is strand of the growth literature that identifies more fundamental determinants of growth.

This literature has identified three deep determinants of growth. These include trade, institutions and geography.

Here, anecdotal evidence also suggests that many of these factors and their effects are influenced by public expenditure. Poor geography may at least partially be overcome through, for example, public spending on better infrastructure links, public-health programs and agricultural research.

The quality of institutions also depends on public services such as the judiciary and public administration, which are both, at least partially, financed through public spending.

Further, trade costs are influenced by the level and quality of publicly financed services, partially or totally, such as customs, trade logistics and transport links.

From a policy perspective, it is essential to understand what types of public spending allocations promote long-run growth in a particular country setting.

However, this is easier said than done.

Given that fiscal policy is subject to inherent trade-offs that arise in part due to government budget constraints, which are difficult to evaluate.

The fundamental property of government budget constraint is that, like any other identity, it requires every fiscal change to be offset by a compensating change. Increases in a certain category of public spending must be financed by increases in tax revenue, in the deficit, or in the level of grants.

Otherwise, other types of spending would have to be lowered, or the off-setting mechanism could be a combination of some or all those elements. The net effects of any fiscal change on growth therefore depend on the way it is off-set.

The direct and indirect growth effects of the off-setting element may have similar or opposite signs. In addition, the growth effects of alternative offsetting changes are likely to differ in magnitude and time horizon.

Since not all types of public spending have the same level of importance, increasing certain public-spending types at the expense of others, affects long-term growth.

Therefore, the relative productivity of different public expenditure categories is critical for policy makers to determine the composition of public spending. To this end, policy analysis sometimes distinguishes between capital and current government spending to predict the growth effects of public spending.

Underlying this categorisation is the belief that capital spending leads to the accumulation of public capital and therefore to higher economic growth, whereas current or consumptive spending affects, at best, welfare, while being growth neutral, or in a more pessimistic scenario, is growth inhibiting and may not even affect welfare.

However, this approach is being increasingly questioned by economic research.

In models of growth and public finance, the growth effects of public spending depend on whether the particular types of public spending affect the productivity of labour and private capital, and on the magnitude of these effects.

In other words, whether public spending results in the accumulation of public capital is less relevant. Rather, through affecting private productivity, certain types of public spending potentially raise the returns to investment and thereby the rate of total (private and public) capital accumulation.

It is the latter transmission channel that is essential to understand the effects of public spending on growth. Further, alternative approaches emphasise that it is essential to consider capital and current expenditures together, given the fact that they usually have a joint effect on growth and that their distinction is often mechanical and artificial in practice.

Given the government budget constraint, the effects of increasing the overall level of public spending on growth are ambiguous.

During economic downturns, governments may increase public spending as a means of stabilising aggregate demand.

Ideally, stimulus packages meet both the objectives of short-run output stabilisation and long-run growth promotion, but, in practice, numerous trade-offs arise.

The objective of short-run stabilisation often dictates that any public investment projects financed be labour intensive and able to be quickly implemented.

By contrast, large and complex investment projects (such as major roads, railways or electricity generation facilities), which are often required to remove bottlenecks for growth, are more likely to be subject to long implementation lags and may be less labour intensive, and therefore less attractive as stimulus plans.

Tags: , , , ,

  • Filling in the gaps – understanding white space spectrum
  • A vision for an African infrastructure agenda
  • The changing landscape of financial inclusion
  • The importance of financial inclusion in the developing world
  • 28 Responses to “The importance of public spending”

    1. Wynand #

      “Given the government budget constraint, the effects of increasing the overall level of public spending on growth are ambiguous.”

      We need to take control of our natural resources (partial nationalization of key strategic industries), that’s the only way we are going to increase revenue and be able to increase spending further, given the budget constraint and our limited tax base.

      Bolivia increased its revenue vastly when in it renationalised some of its mining industries and has experienced sustained and strong economic growth ever since, lowering debt to GDP from 80.4% in 2006 to 32.9% in 2012. It has also run a budget surplus since 2006 (it’s a good example of Keynesian fiscal policy correctly implemented). The situation is much the same in Ecuador. If a poorer and less developed country like Bolivia can do it, then so can we.

      December 7, 2012 at 10:50 pm
    2. Christiaan #

      Mr Chetty is principly right in his approach and discussion. However I think we have a problem in SA that may very well undo much of these “expected benefits” of public spending.

      Our public system is now so bloated with inefficiencies that the cost of delivering any public programme in South Arica is disproportionally expensive and inefficient. And then I am not even talking about all the Government corruption.

      Point in case: OR Tambo Airport is now one of the ten most expensive airports in the world, the SANRAL Gauteng-toll road is one of the most expensive road in the world per km built for this type of geography, the administrative cost of the Toll project is 50% of the value of the project, M&G reported this very week that a job creation project by Government actually cost R4 million per single job created! What is wrong here?

      In my view the disastrous application of the ANC’s (socialistic) policies, BEE policies, cadre deployment and mismanagement of parastatels and municipalities, labour policies and the catastrophic Basic Education Department etc. have now put Government in a death-screw, inefficient mode from which we cannot escape. We simply cannot reap the public spending benefits mr Chetty is talking about – these apply to “normal” economies. Our Public spending will only be on the back of huge debt increases with little real results

      South Africa will be condemned to less than 3% GDP growth for the next few years no matter what..

      December 8, 2012 at 5:34 am
    3. Free Enterprise #

      There is hardly a single thing government can do better than private individuals, with a few exceptions. SA’s parastatals are a good example – from SAA, Eskom, Transnet, ACSA, Denel to the smallest municipalities – bloated, wasteful, inefficient, expensive, overstaffed, lazy. SAA is a good example – with massive numbers of staff per customer, high charges, and still making a huge loss. Probably the only thing the state can do better than private individuals is national defence, simply due to the nature of the service.

      December 8, 2012 at 9:19 am
    4. Juju Esq. #

      Wow, this is what I like to hear. Good analysis Lee-Roy. Good comment Wynand.

      December 8, 2012 at 10:45 am
    5. jandr0 #

      @Juju Esq. I disagree. I think Wynand’s comment is typical of all his comments. He takes one or two “examples,” removes or elides any context or facts that may contradict his pre-decided expectation, and declares (incorrectly) cause-effect relationship.

      Voila, he has just “proven” his fallacious ideas.

      Yeah, right. He thinks I am a stupid fool. So I have never heard of “cum hoc ergo propter hoc” (the fallacy). So he thinks I don’t know there are things like anchoring, confirmation biases, etc.

      I want LESS government interference. As Free Enterprise states: “There is hardly a single thing government can do better than private individual” (statement supported by numerous examples).

      By the way: If I take all the ramifications of Keynesian fiscal policy, which Wynand is so proud that it was “correctly implemented,” I end up with visible theft.

      Wynand feels bad about something, so to make him feel better, he wants to steal from others. I understand that he feels bad, but in my opinion, it still makes him a thief.

      Lee-Roy Chetty: I sometimes get the idea you also cannot wait to put your hands in my pocket and steal the money I worked VERY hard for, just because you feel bad. Don’t feel bad now. C’mon, really get rid of your guilt: I hereby give you my full support for YOU spending YOUR money like you suggest if that will make YOU feel better.

      Wynand: Like I said, I understand your feelings. I disagree with your proposed cure.

      December 8, 2012 at 5:03 pm
    6. Juju Esq. #

      @jandr0

      You say “@Juju Esq. I disagree. I think Wynand’s comment is typical of all his comments.” then you say “I want LESS government interference.”

      You are the one repeating yourself despite excellent work by Joseph Stiglitz, Naomi Klein, John Maynard Keynes, and many many more, showing you are wrong.

      Rather read Lee-Roy’s article again and realize there are many many people who have a better grasp of economics than you.

      PS. Wynand backs his comment up with examples from Bolivia and Ecuador, but if you prefer to believe in the same American Tea Party type philosophy that marginalizes the poor and has recently nearly brought South Africa to the brink of a bloody workers revolution, so be it.

      December 9, 2012 at 10:55 am
    7. Brian B #

      Ok lets get real.
      Governments in general waste money.
      Public spending can never replace private enterprise growth to sustain ably stimulate the economy. That’s what generates tax income to pay for services and infrastructure.
      South African central provincial and local government are imbued with corruption graft and nepotism , which means that public spending is wasteful and often inappropriate.
      Sorry Leroy you cant rely on them.

      December 9, 2012 at 12:41 pm
    8. Juju Esq. #

      @Brian B

      Corruption, graft and nepotism have to be brought under control either way. They are just as bad or even worse when you have croney capitalists like the present group in charge. Free enterprise in South Africa equals tendrepreneurs anyway.

      The solution; bring corruption, graft and nepotism under control, then implement and enjoy the benefits of public spending.

      December 9, 2012 at 1:13 pm
    9. jandr0 #

      Juju Esq.: Well, that was easy, not? Simply declare me wrong.

      I disagree with you on the value of Stiglitz, Klein, or Keynes’ work. (I do not say they have no value, just that I apparently do not rate them to the same heights as you.)

      You are aware that both the Chicago School and the Austrian School completely contradict Keynes’ assessment of the Great Depression?

      The fact that something has become “accepted, conventional wisdom” (or should I say orthodox dogma) does not make it right.

      While my initial personal studies of economics focused on mainstream, I also later accorded fair, reasonable audience to other views, and that has made it clear to me that Keynes is not some infallible guru from the mountains.

      Have you been similarly open-minded?

      My opinion: Keynes’ legacy is legitimised theft. Only the resilience of individuality and entrepreneurship is still managing to keep the USA somewhat competitive against the negative Keynesian impacts. How long Germany can hold out against those euro-theft Greeks and Italians I do not know.

      “… realize there are many many people who have a better grasp of economics than you.”

      Thank you. Intentional disparagement of my knowledge acknowledged, although your only substantiation is referencing current establishment orthodoxy.

      PS. Thanks for agreeing with me: Wynand did only provide selectively-quoted examples from Peru and Equador, ignoring full context. It is called selection bias.

      December 9, 2012 at 3:46 pm
    10. Wynand #

      @ Juju

      Thanks for your excellent comments; I couldn’t have made a better defence of my position.

      @ jandr0 and @ Brian B

      What silly little market fundametalists you are. You don’t even realise that you are the actual extremists, believing in your little market god just like good little religious zealots. You make sweeping assertions about the virtues of free markets when nothing of the sort has ever existed anywhere or ever will. All markets are based on rules and regulations. You just like the rules to be skewed to the benefit of the wealthy. If not, WHO decides where, when, how and what can be traded?

      So, more examples of countries which own partially or wholly their natural resources and more… Chile (Codelco, state-owned copper company, not even Pinochet dared privatize it, one of the biggest Copper producers in the world), Mexico (Pemex), Indonesia, Russia (Gazprom), Brazil (Petrobras), China (where do I start…), India (the list is very long too), SINGAPORE!!!! (Temasek holdings, a state-owned enterprise conglomerate contributes up to 60% of GDP in Singapore, not to mention that 85% of all land is owned by the Singapore government and that it provides 95% of all housing, free market? I think not), Ecuador, Bolivia, Argentina, and many more.

      If anything, SA is the pariah among large emerging market economies in terms of ownership of natural resource based industries. Funnily enough it’s also one of the least corrupt. (See Transparency Intl)

      December 9, 2012 at 7:06 pm
    11. Juju Esq. #

      @ jandr0

      I read up on the economics of the Chicago School years ago. I think they are a bunch of international thugs, or at least their policies were adopted by a bunch of international financial/economic thugs. As Wynand says they are extremists. Professor Joseph Stiglitz documents their hi-jinks well in some of his books.

      What more can I say? We have to agree to disagree.

      December 10, 2012 at 12:26 pm
    12. jandr0, the “Chicago School” is the same as the “Austrian School” — namely, plutocratic fascists seeking to impose terrorist regimes in order to plunder the poor, as happened in Austria itself before the Anschluss, and in Chile under the Friedmanites.

      Capitalism requires a massive redistribution of wealth in order to function, because large numbers of people have to buy large amounts of things. That’s only possible with a government doing the redistributing. That’s why Keynesianism is the only game in town, unless you’re talking socialism. In either case, Chetty is right.

      Nobody looking at South Africa today would say that less public spending is the solution. The problem is that too much public spending is going into corrupt private pockets. Which means that what is needed is a stronger, efficient government, not the weak and corrupt one which the neoliberals want, and which has led to the global market crisis.

      December 10, 2012 at 12:42 pm
    13. Juju Esq. #

      In addition @jandro

      You regard Keynesian economics as theft. But without Keynesian economics capitalism would more than likely have collapsed and dissapeared long ago.

      1) “In 1999, Time magazine included Keynes in their list of the 100 most important and influential people of the 20th century, commenting that: “His radical idea that governments should spend money they don’t have may have saved capitalism.”[9]
      ^ Robert Reich (29 March 1999). “The Time 100: John Maynard Keynes”. Time (magazine). Retrieved 18 June 2009.[

      2) Keynesian economics provided the theoretical underpinning for economic policies undertaken in response to the crisis by Presidents George W. Bush and Barack Obama of the United States, Prime Minister Gordon Brown of the United Kingdom, and other heads of governments.[8]

      Much more here:
      http://en.wikipedia.org/wiki/John_Maynard_Keynes

      So, once again, Keynesian economics come to the rescue after market fundamentalists have brought the world to its knees.

      December 10, 2012 at 12:46 pm
    14. Brian B #

      Wynand,

      Yes all markets are based on rules and regulations and state intervention is beneficial in some cases.
      However to somehow believe that our happy band of demagogues have the capacity, will or energy to achieve what you are alluding to is not silly but downright foolish.

      December 10, 2012 at 1:34 pm
    15. jandr0 #

      @Juju Esq.: Credit to you, here you are engaging without labelling. Thank you.

      “But without Keynesian economics capitalism would more than likely have collapsed and dissapeared long ago.”

      You are welcome to say that. However, you are aware that it is speculation. The phrase “more than likely” gives that fact away.

      “In 1999, Time magazine included Keynes in their list of the 100 most important and influential people of the 20th century, commenting that: “His radical idea that governments should spend money they don’t have may have saved capitalism.”

      Yes. He definitely was one of the most influential people, but so was Churchill, Hitler, Stalin, Mao Zedong, and Rooselvelt. However, the world would be very divided between them very the influence was good or bad!

      Secondly, there is a vital word in there that says “may” have saved capitalism. So, you have to agree, even the way Time magazine phrases it, it is clear that it is speculation. Yes, their author may THINK the speculation is justified in some way, but it is still speculation.

      I would be very glad if you could PROVE it to me.

      “So, once again, Keynesian economics come to the rescue after market fundamentalists have brought the world to its knees.”

      Your claim.

      To take one example: My theory says Keynesian economics CAUSED, for instance, the last “great recession.” Housing market bubble. Some related effects: Mortgage-backed securities, massive credit default swaps.

      December 10, 2012 at 8:19 pm
    16. Jack Sparrow #

      I won’t enter the debate regarding economic ideologies but rather follow the Creator who, I think, is inplying that the key is efficiency or productivity. In a national sense, whoever provides services and infrastructure most efficiently should do so. If government does so, managing their efficiency is a major challenge. If the private sector does the provision, ensuring fair profit vs taxation and regulation is a challenge. In between is a mix; the so-called PPP.

      In SA, government has pretty much shown that they cannot provide services or infrastructure efficiently, if at all. To me, it does not even seem they can regulate, licence, incentivise whatever, the private sector without gross imbalances occurring. My gut feel tells me efficient, honest, competent government and a privatised or PPP delivery system is the way to go.

      December 11, 2012 at 7:28 am
    17. Juju Esq. #

      @Brian B

      If I had your view on life I would leave South Africa and go and live somewhere else. But you may just find that they also have their problems. The grass is always greener over the septic tank.

      December 11, 2012 at 9:05 am
    18. Wynand #

      @ Jandr0

      “Credit to you, here you are engaging without labelling. Thank you.”

      Yes, credit to him, for keeping a cool head. But I couldn’t resist calling a spade a spade after you basically labelled Lee Roy, Juju, and I “bleeding heart liberals”. By the way, Chile’s STATE-owned copper company is THE BIGGEST copper producer in the world. Just thought I’d correct a small error in my previous post.

      “I would be very glad if you could PROVE it to me.”

      Again you ask for proof but provide NONE of your own to support your assertions. How did Keynesianism cause the great recession? Please explain it to us.

      @ Brian B “Governments in general waste money. Public spending can never replace private enterprise growth to sustain ably stimulate the economy.”

      This passes for received wisdom among the converted to the religion of the free market and is the reason why I replied to you too in my tirade against market fundamentalism. So, then, how do you account for Petrobras, Codelco, Temasek holdings, etc?

      The state is better suited to run natural monopolies than the private sector, that’s why public education and healthcare is more cost effective in most other advanced countries than the US, while the health and education outcomes are the same or better in the other countries. Ethically, these services should not be in the private sector because they are in the UN human rights charter, but I have nothing against private run services unless they derive from…

      December 11, 2012 at 11:21 am
    19. Wynand #

      The last sentence of my previous post reads:

      Ethically, these services should not be in the private sector because they are in the UN human rights charter, but I have nothing against private run services unless they derive from the privatizatin of public ones.

      December 11, 2012 at 11:25 am
    20. Juju Esq. #

      @jandro

      You say “I would be very glad if you could PROVE it to me.”

      You have not proven any of your beliefs/theories opposing Keynesian economics yourself on this thread, so how can you demand others prove something to you? You really make me laugh.

      December 11, 2012 at 11:53 am
    21. Brian B #

      Juju Esq.

      My view of life does not extend to turning a blind eye to blatant abuse of power and getting lost in text book socio economic drivel while the mainstream are being robbed of their opportunities to improve their quality of life.

      December 11, 2012 at 1:12 pm
    22. Wynand #

      @ Brian B

      There is no doubt that corruption and abuse of power are damaging South Africa and it’s economy, but this claim simply does not follow:

      “My view of life does not extend to turning a blind eye to blatant abuse of power and getting lost in text book socio economic drivel while the mainstream are being robbed of their opportunities to improve their quality of life.”

      How is it possible that countries way more corrupt than SA are fairing much better in terms of standard of living, unemployment rates and economic growth rates?

      http://www.transparency.org/cpi2011/results/

      Indonesia, Argentina, Brazil, Russia, China, Peru, Venezuela, etc. are all medium high to high level of development countries just like SA, yet they all have single digit unemployment rates and have seen better economic growth rates over the past ten years.

      What sets SA apart from the others is that it is in the top ten of the World Bank’s ease of doing business index for upper middle income countries. The only other country in the above list also in the top ten is Peru, below SA at number 9. Market fundamentalism is what has damaged our economy since the end of Apartheid. Even Madiba unfortunately praised free markets in a 2003 talk at a university in the US.

      December 11, 2012 at 5:06 pm
    23. Stuff #

      @Brian B

      Very philosophical. What is the solution to your quandary?

      @Wynand

      If only people would read Joseph Stiglitz books of the last 12 to 15 or so years. So much documented information. I am not saying others have not documented the same information, but unless people read reliable sources, you and me are farting against thunder.

      December 11, 2012 at 9:06 pm
    24. jandr0 #

      @Juju: Now you’re getting it! The same applies to you!! You have not proven it either, and have now actually declined to do so.

      So will you kindly refrain from derogating my view if you can also not prove your view.

      However: Let’s get very, very basic (I have to, because “characters available” are scarce). I assume you agree (at least to some extent) in the basic laws of supply and demand?

      So simple, if the supply of money doubles, then so will the price of everything. Now, if government doubles the supply of the money, but I don’t get any of the newly available money, then my nominal amount of money will remain the same, but I will be able to buy half of what I have been able to buy before (so much of the real value of my money will have been destroyed).

      Net result: The government has stolen from me.

      Yes, there are numerous ifs and buts which alter the impact (and I suspect you will now raise quite a few). But they do not alter the principle.

      December 12, 2012 at 12:15 am
    25. Wynand #

      @ Jandr0

      Ahh, the old *inflation is theft* argument. Tell that to the South Koreans who had inflation of around 20% over nearly 2 decades and also experienced some of the fastest seen economic growth and economic development over same period. Argentina is another case in point.

      In fact studies by one World Bank ex-chief economist, M Bruno, and William Easterley, a prominent neoliberal and also ex-senior economist at the WB, show that inflation of up to 40% has no effect on growth. If real incomes and living standards are rising faster than inflation, then the inflation problem disappears.

      In fact, an obsession with inflation can destroy economies, just as Germany’s obsession with inflation is now doing to Europe. Too low inflation can be a bad thing if you are a highly indebted country and on a pseudo-gold standard (the euro), as it only amplifies deflationary pressures.

      Given the weak demand in the SA economy (see 2010 OECD survey of SA p 100), you’re basically telling us that to preserve the value of your idle resources (excess savings, based on the disproportionate importance you’re giving this matter) you don’t mind a 25% unemployment rate, the worst inequality rate of the large countries, and some of the worst economic outcomes in the world. I’m sorry, but an obsession with low inflation in an economy running below potential is a trade-off with growth and employment:

      http://krugman.blogs.nytimes.com/2011/12/09/inflating-your-way-to-prosperity/

      December 12, 2012 at 11:54 am
    26. Wynand #

      @ Stuff

      “If only people would read Joseph Stiglitz books of the last 12 to 15 or so years. So much documented information. I am not saying others have not documented the same information, but unless people read reliable sources, you and me are farting against thunder.”

      Agreed, what I’ve learned I owe to the brilliance of economists like Joe Stiglitz, Paul Krugman, Ha Joon Chang, Dean Baker, Mark Weisbrot, Mariana Mazzucato (I highly recommend Chang’s books *Bad Samaritans* and *23 things they don’t tell you about capitalism*, it packs some powerful mojo to ward off the myths and fantasies of free market cultists).

      Though, I don’t agree that we’re farting against thunder. I think these economists provide us with some powerful tools with which to deconstruct prevailing myths and conventional wisdom regarding economics. Thanks to them, I no longer accept any assertions that are not backed up with hard empirical economic data, analyzed and interpreted from within the framework of coherent and verifiable theories. In my opinion free marketeers fall into the same category as people who don’t believe in climate change or evolution.

      December 12, 2012 at 12:20 pm
    27. Brian B #

      Possibly the difference lies in the creation of work opportunities instead of trying to redistribute wealth..

      December 12, 2012 at 2:19 pm
    28. Wynand #

      @ Brian B

      What redistribution of wealth? Of the larger countries, SA is the most unequal in the world:

      https://www.cia.gov/library/publications/the-world-factbook/rankorder/2172rank.html?countryName=South%20Africa&countryCode=sf&regionCode=afr&rank=2#sf

      What impedes creation of work opportunities? SA is in the top ten of upper middle income countries in terms of how easy it is carry on business activities according to the World Bank. Is it not the private sector’s role to create work opportunities? If it is so relatively free to do business how it chooses, what prevents it from creating work opportunities like its less free counterparts in the other countries?

      I’ll tell you what, lack of demand. See the OECD 2010 economic survey of SA p100. According to it, the main reason for persistent high unemployment in SA is lack of demand for labour. Since SA is a place where it’s easy to do business, this can only be because the economy is running below potential and therefore businesses are not hiring more workers because they are not seeing the demand for their goods and services growing. In other words, it is overwhelmingly NOT a supply-side structural problem, but a demand-side one. The only other actor capable of stimulating demand is the government because the Rand is too strong for it to come through exports. So government needs more revenue to stimulate growth, with a limited tax base, that means at least partial nationalization of key strategic industries.

      December 12, 2012 at 4:16 pm

    Leave a Reply

     characters available