A large deficit is OK if it’s spent on investment?

 

Olivier Blanchard (former chief economist at the IMF) made a submission to the US House of Representatives  Committee on the Budget recently. He claimed, “First, deficits, running at more than 5 percent of GDP, are large. Unless they are used to finance an ambitious and credible public investment plan, they should be decreased.”

Well unless I’m much mistaken, the size of the deficit determins the amount of stimulus an economy gets, regardless of whether the deficit is caused by extra capital or current spending. So if a country goes for an excessively large deficit and tries to justify that on the grounds that the deficit arises from extra capital spending, it will find itself with excess demand and excess inflation. 

And what adds strength to the latter point is that there is actually no sharp dividing line between capital and current spending. To illustrate, does something designed to last one year count as capital or current spending? Or should the dividing line be six months or two years or what?

Of course that is not to suggest that a substantial increase in public investment might not be desirable. But the idea that it can be funded via public borrowing is very questionable. At least, if a big increase in public investment is funded via borrowing, that will push up interest rates which will cut private investment, presumably not the effect that those who back more public investment would want.

In short, the world of macroeconomics is very different to the world of microeconomics. That is, borrowing to invest can make sense for a microeconomic entity, e.g. a firm or household. Unfortunately the same does not apply in the world of macroeconomics: a big increase in public investment has to be funded via extra tax, unless we want the extra public investment to be matched by a cut in private investment.