How Much Counter-Cyclical Spending Is Too Much?

I try to keep Macrofugue as far away from theory – and as close to empiricism – as possible.  Today will be a little different.


Above is the y/y inflation rate pitted against Output Gap (Real GDP as a fraction of Real Potential GDP).  Potential GDP can be measured different ways (sometimes as simple as using a constant growth rate trend-line, but more serious estimates contrast the present unemployment with a natural unemployment rate estimate as a measure of aggregate slack.

When the fraction is greater than 1, the situation is called an Inflation Gap.  This is generally viewed as an unsustainable economic situation where inflation will outpace growth as demand outstrips supply.  The inverse is an output gap – the economy’s capacity is not being fully utilised.

The role of the public sector is to serve the private sector.  While Keynes expressed the optimal model leaves “private initiative and enterprise unhindered“, there are things governments just do better (ask the Ontarians how Ontario Hydro’s privatisation has fared), and areas that it is the natural (and sometimes only) provider of services (welfare programmes, the military, education, infrastructure).

Private enterprise does not flourish under periods of volatility.  Growth, innovation and employment take investment — and investment is risk taking.  Risk-takers don’t make the jump unless the underlying environment is stable.  It is no coincidence that the past century — particular the past 4 decades — have seen the largest leaps in technological innovation, wealth, improvement in standard of living, and increase in longevity in the history of humanity at the same time that economic volatility has largely been managed by the major central banks & political powers.

Conversely, the process of economic evolution left “unhindered” is an important mechanism for maintaining an upward trajectory of productivity, innovation and competitiveness.

The services the government provides to the private sector are two-fold:  to fulfil the social objectives of society, and to enable private initiative and enterprise.


The former provides stability in the form of a catastrophic failure net.  As Maslow’s hierarchy of needs theorises, physiological needs must be satisfied first – and it further takes the needs of safety, belonging & esteem met before the self-actualisation behaviour of advanced problem solving and creativity can be let loose.  I believe this to not be true for just individuals, but also for nations and societies.

Naturally, there is a cost to the services the government provides.  The usual framework for analysing this is spending in either absolute terms, or relative to the size of the private sector.  This is inadequate: we must also measure it against estimating how much smaller the private sector would be in in aggregate without it.

Let’s examine the arguments against spending levels:

“Government Debt Displaces Investment Capital”

This is backwards.  In other countries, this is true, but the United States owns their own means to money creation, and they are using it.  The evidence is fairly clear that, in practise, the funding mechanism is the creation mechanism:


This is a transaction from the public sector to the private sector.  The private sector then invests or saves the proceeds (likely after several more private sector transactions, but ultimately ends up as deposits anyway; most of this ends up being lent out either to the government in bonds, Federal Reserve in IOER, or to other private borrowers).


“Government Economic Activity Displaces The Private Sector”

This can certainly be the case with less private slack, or if the public spending competes for specific resources with private buyers, but is untrue in and of itself.

There are at least 7 million payrolls of employment slack.  Public spending is not displacing the private sector bid for labour.  This is further evidenced by near-zero wage-growth.

Capacity utilisation — the means of production — has been recovering very steadily, but still remains at just 77.4% — down from more than 81% from before the credit contraction.

It is clear that Net Government Spending through an output gap this large presents a minimal inflation risk.

 Net Government Saving = Private Liability.  Period.


When Net Government Savings increases, the resulting loss of private income has only two possible outcomes:

  1. It causes a decrease in aggregate demand which is commensurate with the increase, or,
  2. It is replaced by private credit growth

The private credit growth model has further been supported by the Federal Reserve adjusting rates counter-cyclically.  This, of course, didn’t function as it had before when the confidence in private credit evaporated in 2008.


The total slack in the system is still north of $700B.  The threshold of how much extra Net Government Spending it would take to fill that gap without causing meaningful inflation (or damage our competitiveness) depends on what it is spent on.

My vote is tax cuts and infrastructure spending — but that’s politics.  What is clear:  the Federal government can and should spend more.


This post previously appeared at Macrofugue >