Abstract: Is there a role for government in the
economy? Yes, says Heritage analyst Karen Campbell--but the
government must focus on maintaining economic stability. Fiscal
responsibility is an important part of that stability. Government
debt can quickly become a burden on the economy and weaken its
foundations. Sound macroeconomic policies enhance the credibility
of the government and strengthen the political institutions. This
credibility is vital for economic stability and Americans'
long-term investment decisions that allow the U.S. economy to
In order to restore economic stability, policymakers must focus
on restoring the institutional role of governing. Government can
provide a stable environment for economic growth when it can be
depended upon to maintain the stability of the currency, enforce
and defend property rights, and provide oversight that assures
private citizens that their transaction partners in the marketplace
are held accountable. This will allow market participants to
begin putting their resources back to work in the areas where they
are most beneficial.
After decades of lecturing developing countries on how to emerge
from economic crisis and stimulate economic growth through sound
government policies, U.S. policymakers and some economists are
throwing out all their advice during the first major crisis test.
This is particularly true when it comes to advice on accumulating
more and more debt.
President Barack Obama's fiscal responsibility summit last
February indicated that he understands the urgent need for fiscal
discipline. But Congress's recent enactment of the American
Recovery and Reinvestment Act and the President's proposed budget
makes the goals of a sustainable budget and addressing the nation's
longer-term fiscal priorities, such as entitlement liabilities,
even more elusive. The Congressional Budget Office's recent "Budget
and Economic Outlook" estimated the 2009 budget deficit to be $1.6
trillion. The Administration's recently released
mid-session review from the Office of Management and Budget
estimates that over the next 10 years the accumulated deficits will
total $9 trillion. This means that the debt held by the public
will be a staggering 77 percent of GDP in 2019. If the debt level
continues to grow faster than the economy, the U.S. will find that
it owes more than it makes.
Government spending and government deficits automatically
increase during economic downturns due to more demands on
social-safety-net provisions and falling tax revenues. Such
spending can have a stabilizing effect on the economy because it
happens automatically rather than through legislative acts, and the
money is spent at times it is needed most. Borrowing and spending
to stimulate the economy using legislative discretion is much more
difficult to time for the right moment, and is thus much riskier.
The funds are often not spent until long after the downturn has
taken place, and can prolong the downturn by crowding out
productive investment and spending that would have otherwise
Economic downturns, while painful, do afford an opportunity to
root out waste and inefficient spending both in the public and
private sectors. This is because the opportunity cost of making
fundamental reforms is lower during downturns. This opportunity to
reassess processes and undertake reforms that make better use of
resources should not be wasted.
As with all of economic life, there are trade-offs. Government
deficits have both positive and negative effects. Debt is a
powerful tool that can magnify gains, but its leveraging power is
dangerous because it also magnifies losses. Debt should be used to
finance income-producing assets that will be used to pay back the
debt. Using debt financing to pay for consumption or unproductive
assets can lead to a sinkhole as the outflow of interest and
principle payments becomes larger than the inflow of income. In the
case of small budget deficits, the positive effects most likely
outweigh the negative effects, for example, of increased risk and
interest rates. As the deficit grows, the negative effects of
adding to the nation's debt start to overwhelm any positive
Large deficits can contribute to price instability. If the
government finances the deficit by printing money, it can lead to
inflation through depreciation of the currency, which makes foreign
goods more expensive. This puts increasing pressure on the domestic
price level by raising the price of imports. If the government
issues debt, competition with businesses and other individuals for
investment dollars results, increasing the cost of borrowing to
finance productive investments in the private sector.
A weak fiscal position can weaken government's ability to
provide security for property rights. Being overleveraged makes it
that much more difficult to borrow in the face of a security crisis
or other unforeseen catastrophe. The government can also lose its
role as a credible governing body (overseer) of markets when it
becomes an active participant in the markets. Careful arms-length
oversight will also promote clarity, so that reliable information
about goods and services is available to those buying and selling
in the market, allowing good price signals to come out of the
market system. This minimizes distortions and enables people to
make the best possible decisions about how to spend their
The Global Economy: Makes Sound
Institutions More Critical
In economies that compete globally, the government's
creditability is even more crucial. This creditability is dependent
on the fiscal responsibility of the government. The International
Monetary Fund (IMF) has long advocated fiscal restraint to
establish credit for emerging economies. The established credit of
the U.S. is largely due to the strength of its financial
institutions. The U.S. should not abuse its greater fiscal
flexibility in terms of its debt, but instead should work to
maintain the credit of the U.S. government.
Preserving the credibility of the United States abroad is not
only a diplomatic exercise. Large fiscal deficits in developed
economies not only crowd out investment in the private sector, they
compete with the debt issued by emerging economies. When many
developed economies issue debt simultaneously, the cost and
availability of funding for developing economies increases and
limits the ability of developing countries to raise much-needed
external funding as they work toward economic development.
Sound fiscal policy and a credible commitment to deficit reduction
will help keep the United States a world leader and good citizen of
the global economy.
The Danger of the "Kitchen Sink"
Many believe there is a danger of doing too little. In fact, the
danger probably lies in trying to do too many different things in
the hope that one of them will restore economic growth. By doing
too much there is a greater chance that policy effects will offset
one another (for example, providing a tax cut on investments that
gives people an incentive to invest, while increasing government
investment that raises the cost of investing).
The investment ambitions, while admirable, can be achieved in a
decentralized way if the government once again focuses on its
supportive role of providing a solid economic foundation. Given a
stable foundation, private individuals can invest and produce the
vibrant standard of living that meet the changing needs and wants
Government institutions must be managed well to guard their
credibility in providing a just system of laws and enforcement.
This can be starkly evident in less-developed countries but is no
less true for developed countries.
For a developed economy, well-run government institutions are no
less important. Effective government institutions ensure that those
employed in the public sector are doing their jobs effectively,
with the goal of supporting the private sector, not
competing against it. Rather than borrowing more money and creating
new programs and layers of bureaucracy, this Administration and
- Focus on the election campaign promise of streamlining
- Exercise restraint in rushed deficit spending projects with no
- Focus on financial regulatory reform;
- Reform the tax code; and
- Signal a commitment to trade rather than protectionism.
The first two points demonstrate a commitment to fiscal
responsibility and give an opportunity to review the purposes of
agencies in light of current needs and changing technology. This
will help to increase the level of accountability in both the
private and public sectors, as evaluations shine the light on how
operations have been conducted. Demonstrating fiscal responsibility
also signals a commitment to supporting the U.S. currency,
which will reassure America's trading partners.
The third point will help restore credibility to U.S. financial
institutions. It is well past time to modernize this country's
financial regulatory system so that it can meet the challenges of
today rather than reflect the structure of a market that no longer
exists. The new system should be flexible and encourage the kind of
innovation that has helped to provide low-cost financial services
to millions of consumers, while also providing the credit that is
so necessary for economic growth. It is important that the recent
stabilization in the financial sector and other legislative agendas
do not change the priority of this reform effort.
The fourth, reform of the tax code, should focus on
simplification, transparency of the tax burden, broadening the
base, and lowering overall rates. Reducing the layers and
complexity of the tax code frees up resources that citizens can put
to more productive use. The Tax Foundation estimated that in 2005,
individuals and non-profits spent six billion hours complying with
the federal tax code. This amounts to an additional 22 cents
per dollar of tax collected--which means that American citizens
paid $1.22 for every $1 that the government received in tax
Simplifying the tax code and streamlining the collection process
would allow taxpayers to save this time and money, effectively
giving them more disposable income. Increased disposable income can
help people build wealth. Wealth is built by investing in assets.
With house prices no longer rapidly appreciating, more productive
asset investments might be in infrastructure, energy, health
technology, and other assets of the future.
Reducing marginal tax rates on income both at the corporate and
individual levels increases the benefits that individuals and
corporations receive from using their scarce resources to earn that
income. This increased incentive to use resources productively
creates greater economic growth. As the economy grows, more
investments can be made, which in turn create more opportunities
for growth, employment, and higher standards of living.
Furthermore, economic growth generates higher tax revenues that
support the governing institutions. This positive feedback effect
is in fact a main motivation for many countries to undertake
fundamental tax reforms.
Fifth, trade protectionism requires economic controls either in
the form of subsidies (explicit or implicit), tariffs, or quotas.
Import substitution policies have long been discredited by
development economists. Becoming more closed off to the global
economy weakens an economy, forcing it to spend its resources on
providing goods and services it could buy cheaper elsewhere and
forgoing production of goods and services it could sell abroad at a
higher price than at home. This ultimately raises costs on everyone
and stifles economic growth.
These five recommendations are in fact the prescriptions the
IMF, the World Bank, and developed countries have been giving
developing and emerging economies for a long time. This is because
sound macroeconomic policies enhance the credibility of the
government and strengthen the political institution.
This credibility is vital for the economic stability that is
necessary for making long-term investment decisions.
Citizens receive value from the government's role of making and
enforcing laws that give the citizens the opportunity to freely
pursue opportunities. The fact that the U.S. is a developed economy
does not mean that the government does not need to take reform
measures. The Administration and Congress should not waste this
opportunity to ensure that 21st-century U.S. government
institutions continue to provide a stable environment for
individuals to freely pursue wealth-growing investments.
Having an orderly governing body allows private citizens to make
long-term investment decisions about their personal resources. A
credible governing body contributes to the economic growth of a
nation and provides the best opportunity to accomplish its national
investment and growth goals through the entrepreneurial spirit of
all its citizens. Making fundamental changes to the rules and
agencies that have become outdated and opaque will provide economic
stability and give potential entrepreneurs the confidence to work
toward meeting the ever-changing needs of society.
Campbell, Ph.D., is Policy Analyst in Macroeconomics in the
Center for Data Analysis at The Heritage Foundation.
example, ensuring that voluntary transactions made on the basis of
false claims will be prosecuted is a deterrent for those who might
falsify claims. Knowing that this is a deterrent gives innocent
parties the needed assurance to make voluntary transactions without
having to write costly contingent contracts for every
Robert Barro, Determinants of Economic
Growth: A Cross-Country Empirical Study (Cambridge, Mass.: MIT
summit was convened at the White House on February 23, 2009.
the money is borrowed from individuals or nations outside the U.S.,
this merely changes the channel through which the effects occur
(for example, through exchange rates versus interest rates, etc.).
There is an argument that during recessions the money borrowed was
being hoarded and, therefore, the government-borrowed money carries
no or very low opportunity cost. However, a lender's willingness to
lend to a government during a recession does incur an opportunity
cost represented by the interest payment. Further, this interest
payment and the borrowed funds represent a lost opportunity for
future Americans who must pay back the principle and interest
instead of using those funds to invest or spend elsewhere.
opportunity cost of disrupting and reforming a system during good
economic times when a system is functioning well is lost value that
the system produces. However, in an economic downturn, when systems
have been disrupted, the value that system produces is lower, and
thus the opportunity cost of reforming the system and creating a
better, more efficient process is also lower.
"Crony capitalism" has plagued both developing
and developed economies. Japan's government connection with private
banks is a recent, oft-cited example.
Although in developed and established economies
fiscal responsibility in terms of the government deficit may become
less of a factor in its "credit rating" than for an emerging
economy, there is a tipping point for which the deficit, even in an
advanced economy, becomes a catalyst for a loss of confidence. One
proximate measure of this confidence is the market for insurance
contracts in the event of a U.S. Treasury default. Greg Ip reported
on January 11, 2009, in The Washington Post, "We're
Borrowing Like Mad. Can the U.S. Pay it Back?", that: "Last week,
markets pegged the probability of a U.S. default at 6 percent over
the next 10 years, compared with just 1 percent a year ago." See
/article/2009/01/09/AR2009010902325.html (September 9,
For a discussion of some issues related to
developing countries as well as how thresholds play a role, see M.
Ayhan Kose, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei,
"Financial Globalization: A Reappraisal," International Monetary
Fund Working Paper No. WP/06/189, August 2006. Also see
"Swimming Against The Tide: How Developing Countries Are Coping
With the Global Crisis," Background Paper prepared by World Bank
Staff for the G20 Finance Ministers and Central Bank Governors
Meeting, Horsham, United Kingdom, on March 13-14, 2009, at http://siteresources.worldbank.org/NEWS
William J. Baumol, Robert E. Litan and Carl
J. Schramm, Good Capitalism, Bad Capitalism, and the Economics
of Growth and Prosperity (New Haven, Conn.: Yale University
Press, May 2007).
For relationships between economic freedom
and growth and the way country rankings can change both positively
and negatively due to government policies, see Terry Miller and Kim
R. Holmes, 2009 Index of Economic Freedom (Washington, D.C.:
The Heritage Foundation andDow Jones & Company, Inc.,
Large deficits can increase the political
incentive to depreciate the currency in order to "pay" for the
debt. Recent warnings from China, a large holder of U.S. currency,
give some anecdotal evidence of this concern. See Andrew Batson,
"China Takes Aim at Dollar," The Wall Street Journal, March
24, 2009, at http://online.wsj.com/article/SB123780272456212885.html
(September 9, 2009).
Scott A. Hodge, J. Scott Moody, and Wendy P.
Warcholik, "The Rising Cost of Complying with the Federal Income
Tax," The Tax Foundation Special Report No. 138, January 10,
Dani Rodrik, "Understanding Economic Policy
Reform," Journal of Economic Literature, Vol. 34, No. 1
(March 1996), pp. 9-41. Note: Import substitution is a policy that
pursues development of domestic production capacity of a currently
imported good by protecting the domestic producers of that good and
thereby shielding them from the competitive pressure of the
Amartya Kumar Sen, Development as
Freedom (New York: Oxford University Press, 1999).
For a formal analysis and discussion on the
role of the political institution in creating an environment for a
functioning market order, and the negative investment and
development effects if this institution loses credibility by being
seen as susceptible to capture by powerful constituent groups, see
László Bruszt, "Market Making as State Making:
Constitutions and Economic Development in Post-Communist Eastern
Europe," Constitutional Political Economy, Vol. 13, No. 1