Government spending cuts: only part of the equation


ECONOMY…by Robert Mercer-Nairne

As most of us should know by now (but probably don’t) a country’s gross domestic product (its GDP) consists of its people’s consumption (C), plus their investment (I), plus their collective expenditure – what their government spends (or does not spend) on their behalf (G), plus their net exports – exports less imports (NE). Expanding GDP, denoting a growing economy, is deemed to be a good thing; contracting GDP, denoting an economy in recession, a bad one. At the moment governments in the developed world are struggling to keep the GDP of their countries expanding. But if doing so is such a good thing, why is it proving such a struggle?

Let’s look at the elements of this simple equation: GDP=C+I+G+NE. In Britain and the United States, personal consumption (C) has hit the buffers because much of it was underpinned by debt, built up over many years, that is now having to be repaid. Investment takes place in anticipation of future demand and with demand anemic, investment (I) is restrained. Net exports are improving, partly because imports are being cut back on account of weak domestic demand, and partly because the developing world is still expanding. But NE is not expanding fast enough to make up for the collapse in C. This leaves G.

As even Keynesian’s acknowledge, while collective expenditure undertaken by government on its people’s behalf (G) can be increased to fill the gap, there is a limit. That limit is reached when raising taxes produces diminishing returns and the cost of government debt incurred to sustain unfunded expenditure undermines an economy, either due to the inflationary debasement of its currency or due to the excessive cost of servicing its debt. The current government in Britain is moving the other way – reducing spending to reduce the debt and this will, according to the equation, have a negative effect on GDP.

Monetarists prefer to keep government out of it, arguing that the cost of the money (determined by interest rates as a function of money supply) that flows through the system (GDP=C+I+G+NE) will enable an economy to self-correct. If people consume less and save more the return on money (its cost) will fall and stimulate investment. To them, the debt fueled consumption of prior decades would not have reached such a pitch if interest rates had been allowed to rise (in response to people’s increasing demand for credit) instead of being kept artificially low by various government stratagems, such as subsidized housing and under-funded entitlements.

In a nod to both camps, the authorities in America have cut interest rates to almost zero by flooding the system with liquidity and are also entertaining a record government deficit. Europeans have followed suit with liquidity but are proving less inclined to increase already large government deficits. While recognizing that radical action was needed to prevent the world falling into a depression in 2008, there are many who are uncomfortable with the idea of replacing unsustainable private debt with equally unsustainable government borrowing. But perhaps it is our understanding of consumption (C) – the largest component of GDP in developed economies – that is leading us astray.

The structure of the American economy, in particular, directs personal consumption toward consumer durable and non-durable products (cars, clothes, furnishings, etc.). Thanks to globalization, these are increasingly made in low cost countries outside the United States. This has set up a vicious circle in which people borrow to buy from countries that cannot yet absorb the money generated by their exports, and so lend a large part of it back to their American customers. Anything better designed to result in consumer poverty is hard to imagine.

In the past, a large part of the growth in GDP has been a product of increasing national populations. In fact there are only two ways in which an economy’s GDP can grow – by sustaining a growing population and by increasing its productivity. As an economy matures, one would expect any growth in its GDP to come less from population growth and more from improvements in productivity. Or to put it another way, over time people are likely to shift their preferences from the quantity of products they consume towards the quality of their life as a whole. But what happens if the economic system does not allow them to opt for what are often collective goods? The mess we are in, I would suggest.

By the end of the 1930s GDP began to grow again, thanks to massive rearmament in Europe and America. This was a perverse form of collective expression we must hope not to repeat. The challenge for us today is to build economies that allow people to express their collective wish to live civilized lives, away from poverty at one end and obscene materialism at the other. If this isn’t a task crying out for entrepreneurs, I don’t know what is. The ‘G’ and the ‘C’ in the equation GDP=C+I+G+NE must be forced onto common ground. Unfortunately, the structure of government is both the problem and the solution

Robert Mercer-Nairne is the author of Notes on the dynamics of man,
published by Gritpoul Inc.