One school of thought is holding on to what is irrefutable, almost truistic in Keynesian economics. If demand is for a lesser output than capacity would permit, additional demand by government will be met by additional output. Government demand can therefore be increased up to the limit of output capacity. Some of the extra demand injected by the government will "leak" into imports, increasing the output of foreign countries, but the rest will be met by additional output in the home country. Sacrificing this extra output on the ground that it takes a budget deficit to call it forth is sheer waste and is inexcusable. There is a domestic multiplier by which the extra income generated by filling the output gap engenders the amount of domestic saving needed to equate saving to investment, or what comes to the same thing, to dissaving. The accounting identity of total household and corporate saving must equal domestic investment, net exports and government dissaving, is not in dispute. It is one of the strong attractions of the Keynesian system in which macro-economic sub-totals are linked together mechanically by impersonal constants and variables, so that moving one leads to pre-determined changes in all the others. However, once the economy is not conceived as a great Meccano set, easy to understand and manipulate, but as a locus of individuals' responses to their expectations and perceived incentives, the tempting Keynesian conclusion of filling the output gap by fearless recourse to budget deficits that are never too large as long as the output gap is still open, start to become more and more dubious.
The opposing school that advocates austerity instead of fearless deficit financing, thinks that it has a knockdown argument. It is one of good housekeeping, serious husbandry: it is that you cannot for long spend more than you earn.
Taken strictly, this is not true. You can go on forever spending more than your income (hence getting ever deeper into debt) as long as the cumulative total of excess spending (i.e. the national debt) increases at a rate no higher than the rate of increase of national income. If national income stops rising, the national debt cannot be allowed to rise much further. Counter-intuitively, this condition is harder to satisfy when the national debt is only 25 per cent of national income (the case, roughly, of Rumania) than when it is 80 per cent (the case of France in 2010). Supposing a year when the two economies both stagnate at zero growth and their deficit is at the Maastricht maximum limit of 3 per cent of GDP, the Rumanian debt ratio would jump to 28 per cent of GDP and the French would creep to 83 per cent, a rate of increase of 12 per cent for the former and 3.75 per cent for the latter. Like in the race of the hare and the tortoise, despite the more rapid rise of the Rumanian debt, it would be the French one that first reaches a ratio of GDP at which its burden becomes a millstone around the country's neck because the annual interest charge it imposed would bring about a distribution of incomes that penalises both labour and enterprise to an ever greater degree. The effect would bear some resemblance, though on a less fatal scale to the "demographic time bomb" menacing most European economies that will in coming decades have to maintain an ever larger pensioner class in the style it is accustomed to from the labours of an ever smaller active population.
Evidently, the higher the annual growth of GDP, the higher will be the deficit that can be supported without an increase in the national debt ratio. Here is the nub of the current controversy between orthodox Keynesians and Good Housekeepers about the right fiscal policy to escape the recession. The orthodox Keynesians say that deficit-cutting austerity under present circumstances is sheer masochism. If anything, the deficit should even be increased so as to exploit the output gap, produce more income and more employment. The Good Housekeepers say that deficits are already at the danger level beyond which the debt burden becomes unsustainable. Given the political obstacles to reducing welfare expenditures, and given that failing sharp deficit reduction, the annual service charge of the debt will be increasing, the economy will be caught in a vicious downward spiral of deficits increasing the debt burden which engenders greater deficits until sovereign default in some form finally interrupts the process. Therefore, as Mrs. Thatcher had famously said, "there is no alternative". Austerity must prevail over Keynesian orthodoxy.
Between April 2010 when the Greek "crisis" peaked and July 2010, three of the major European countries, Germany, Britain and France as well as other, supposedly less creditworthy ones have in various forms signalled that they have opted for budgetary austerity. Each has made symbolic gestures ranging from voluntary reductions in ministerial salaries and the laying off of ten thousand official cars and their chauffeurs to the cancellation of state hunts and garden parties. More significantly, a few albeit timid cuts were made in some welfare entitlements, with promises of more to come. The amounts saved are as yet near to negligible, but the fact that social welfare, the most sacred and untouchable of the services governments are elected to provide, is now being cut, is of truly historic importance. Ever since the early post-war years, governments and their oppositions have been engaged in a bidding contest, offering innovations and extensions of welfare services in a fierce competition for tenure. As a result, the share of central and local government spending as a percentage of national income kept creeping ever upward from the mid-twenties in the 1950s to the mid-forties by the turn of the century and in some countries touching 60 per cent in 2009. The "ratchet effect" became the first empirical law of democracy: under majority rule, welfare entitlements are either maintained or increased, but cannot be reduced.
As was to be expected, the competitive bidding in offering an ever more complete and more expensive welfare state to the electorate has generated its own ideological justification. "Social justice", meaning whatever a democratic government did to change the distribution of wealth, income and privileges in favour of particular groups or classes, came to be regarded as self-evidently righteous. Inequalities were understood to be self-evidently unjust. Capitalism was tolerated on the tacit understanding that it does not challenge the social democratic governments of both Left and Right and acquiesces in the extensive redistribution involved in rising welfare entitlements and the targeted provision of public goods.
Accepted political theory teaches that by creating law and order, protecting property and enforcing contracts, the state organizes society out of the state of nature. In doing so, it functions as a factor of production, complementary to labour and capital just as the latter are complementary to each other. It would not be totally outlandish to speak of three factors of production, labour, capital and the state and attempt by regression analysis to estimate the productivity of each separately. We may quantify the factor (state) by the share of public expenditure in total GDP.
This is a Panglossian and even an angelic view of the state that can be badly shaken by doing what the economist worth his salt normally does, that is to look at what happens at the margin. If you increase labour with capital remaining unchanged, the marginal product of labour will presumably diminish and in some rather contrived circumstances might decline to nought. Likewise, by piling on more and more capital to be used by an unchanged labour force, the marginal product of capital will eventually be reduced and might even settle at zero. Imagination, however, has a hard time in conceiving of either labour or capital having negative marginal productivity. It is harder to think of negative factor productivity than of Frederic Bastiat's negative railway.
However, if the state is understood as a factor of production, one of a complementary threesome with capital and labour, the possibility of negative marginal productivity springs to mind as a matter of course. Providing law and order and protecting property and contract (and leaving national defence on one side as too indeterminate to account for in abstract theory) are in peacetime not very costly. Devoting to them 5 per cent of GDP might do the job. In this single-digit zone, the marginal product of the state is probably very high. Though doing so is sheer guesswork, we might suppose that its marginal product is still respectable when state spending reaches 15 to 25 per cent of GDP. But it is more likely than not to be in a declining phase. At what level of state spending it sinks into negative territory is partly a question of the good sense of government, the character and civic culture of the people, the prevalence of corruption and pointless waste, the effect of a social safety net on the work ethic, the effect of taxation on initiative and above-average performance, and so forth. Pages and pages would be needed to list all the factors likely to have some influence. Any conclusion would always be somewhat speculative, perhaps swayed by ideology and prejudice. What matters as much as the elusive objective truth, however, is that large numbers of workers, professional men and entrepreneurs are viscerally convinced that the fully developed welfare state is crowding out parts of the private sector and feels like a millstone about their own necks. Believing this, they act accordingly and make their belief come true.
If so, then two cheers for austerity and two cheers even for the somewhat uncertain promise of it. Two cheers, in other words, for the unexpected and very salutary prospect that the negatively productive factor may at last have some of its depressive margin trimmed.