13.11.2008
It is a maxim of current economic orthodoxy that governments compete with the private sector on a limited pool of savings. It is considered equally self-evident that the private sector is better, more competent, and more efficient at allocating scarce economic resources and thus at preventing waste. It is therefore thought economically sound to reduce the size of government – i.e., minimize its tax intake and its public borrowing – in order to free resources for the private sector to allocate productively and efficiently.
Yet, both dogmas are far from being universally applicable.
The assumption underlying the first conjecture is that government obligations and corporate lending are perfect substitutes. In other words, once deprived of treasury notes, bills, and bonds – a rational investor is expected to divert her savings to buying stocks or corporate bonds.
It is further anticipated that financial intermediaries – pension funds, banks, mutual funds – will tread similarly. If unable to invest the savings of their depositors in scarce risk-free – i.e., government – securities – they will likely alter their investment preferences and buy equity and debt issued by firms.
Yet, this is expressly untrue. Bond buyers and stock investors are two distinct crowds. Their risk aversion is different. Their investment preferences are disparate. Some of them – e.g., pension funds – are constrained by law as to the composition of their investment portfolios. Once government debt has turned scarce or expensive, bond investors tend to resort to cash. That cash – not equity or corporate debt – is the veritable substitute for risk-free securities is a basic tenet of modern investment portfolio theory.
Moreover, the “perfect substitute” hypothesis assumes the existence of efficient markets and frictionless transmission mechanisms. But this is a conveniently idealized picture which has little to do with grubby reality. Switching from one kind of investment to another incurs – often prohibitive – transaction costs. In many countries, financial intermediaries are dysfunctional or corrupt or both. They are unable to efficiently convert savings to investments – or are wary of doing so.
Furthermore, very few capital and financial markets are closed, self-contained, or self-sufficient units. Governments can and do borrow from foreigners. Most rich world countries – with the exception of Japan – tap “foreign people’s money” for their public borrowing needs. When the US government borrows more, it crowds out the private sector in Japan – not in the USA.
It is universally agreed that governments have at least two critical economic roles. The first is to provide a “level playing field” for all economic players. It is supposed to foster competition, enforce the rule of law and, in particular, property rights, encourage free trade, avoid distorting fiscal incentives and disincentives, and so on. Its second role is to cope with market failures and the provision of public goods. It is expected to step in when markets fail to deliver goods and services, when asset bubbles inflate, or when economic resources are blatantly misallocated.
Yet, there is a third role. In our post-Keynesian world, it is a heresy. It flies in the face of the “Washington Consensus” propagated by the Bretton-Woods institutions and by development banks the world over. It is the government’s obligation to foster growth.
In most countries of the world – definitely in Africa, the Middle East, the bulk of Latin America, central and eastern Europe, and central and east Asia – savings do not translate to investments, either in the form of corporate debt or in the form of corporate equity.
In most countries of the world, institutions do not function, the rule of law and properly rights are not upheld, the banking system is dysfunctional and clogged by bad debts. Rusty monetary transmission mechanisms render monetary policy impotent.
In most countries of the world, there is no entrepreneurial and thriving private sector and the economy is at the mercy of external shocks and fickle business cycles. Only the state can counter these economically detrimental vicissitudes. Often, the sole engine of growth and the exclusive automatic stabilizer is public spending. Not all types of public expenditures have the desired effect. Witness Japan’s pork barrel spending on “infrastructure projects”. But development-related and consumption-enhancing spending is usually beneficial.
To say, in most countries of the world, that “public borrowing is crowding out the private sector” is wrong. It assumes the existence of a formal private sector which can tap the credit and capital markets through functioning financial intermediaries, notably banks and stock exchanges.
Yet, this mental picture is a figment of economic imagination. The bulk of the private sector in these countries is informal. In many of them, there are no credit or capital markets to speak of. The government doesn’t borrow from savers through the marketplace – but internationally, often from multilaterals.
Outlandish default rates result in vertiginously high real interest rates. Inter-corporate lending, barter, and cash transactions substitute for bank credit, corporate bonds, or equity flotations. As a result, the private sector’s financial leverage is minuscule. In the rich West $1 in equity generates $3-5 in debt for a total investment of $4-6. In the developing world, $1 of tax-evaded equity generates nothing. The state has to pick up the slack.
Growth and employment are public goods and developing countries are in a perpetual state of systemic and multiple market failures. Rather than lend to businesses or households – banks thrive on arbitrage. Investment horizons are limited. Should the state refrain from stepping in to fill up the gap – these countries are doomed to inexorable decline.
A Note on GDP (Gross Domestic Product)
The formula to calculate GDP is this:
GDP (Gross Domestic Product) =
Consumption + investment + government expenditure + net exports (exports minus imports) =
Wages + rents + interest + profits + non-income charges + net foreign factor income earned
But the GDP figure is vulnerable to “creative accounting”:
1. The weight of certain items, sectors, or activities is reduced or increased in order to influence GDP components, such as industrial production. Developing countries often alter the way critical components of GDP like industrial production are tallied.
2. Goods in inventory are included in GDP although not yet sold. Thus, rising inventories, a telltale sign of economic ill-health, actually increases the GDP!
3. If goods produced are financed with credits and loans, GDP will be artificially HIGH (inflated).
4. In some countries, PLANS and INTENTIONS to invest are counted, recorded, and booked as actual investments. This practice is frowned upon (and landed quite a few corporate managers in the gaol), but is still widespread in the shoddier and shadier corners of the globe.
5. GDP figures should be adjusted for inflation (real GDP as opposed to nominal GDP). To achieve that, the calculation of the GDP deflator is critical. But the GDP deflator is a highly subjective figure, prone, in developing countries, to reflecting the government’s political needs and predilections.
6. What currency exchange rates were used? By selecting the right “points in time”, GDP figures can go up and down by up to 2%!
7. Healthcare expenditures, agricultural subsidies, government aid to catastrophe-stricken areas form a part of the GDP. Thus, for instance, by increasing healthcare costs, the government can manipulate GDP figures.
8. Net exports in many developing countries are negative (in other words, they maintain a trade deficit). How can the GDP grow at all in these places? Even if consumption and investment are strongly up – government expenditures are usually down (at the behest of multilateral financial institutions) and net exports are down. It is not possible for GDP to grow vigorously in a country with a sizable and ballooning trade deficit.
9. The projections of most international, objective analysts and international economic organizations usually tend to converge on a GDP growth figure that is often lower than the government’s but in line with the long-term trend. These figures are far better indicators of the true state of the economy. Statistics Bureaus in developing countries are often under the government’s thumb and run by political appointees.
Sam Vaknin is Associate Editor of Global Politician and Regional Correspondent for the Chronicle Media Group, USA. He is a political and economic analyst and commentator. His articles and books are available here: http://samvak.tripod.com/guide.html
