The Optimum Degree of Government Financial Intervention

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drjohn11aDr. John Psarouthakis, Executive Editor of www.BusinessThinker.com, Distinguished Visiting Fellow at the Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland, publisher of www.GavdosPress.com and Founder and former CEO, JP Industries, Inc., a Fortune 500 industrial corporation

The central question in many economic debates is how much should the government intervene in the economy. In other words, what is the optimum level of government spending? In a recent paper, Psarouthakis et al. (Economics and Finance Notes, 2012) show that the answer is a function of the country’s level of economic development.

According to this research, the economy is a complex system in which firms, households and the government interact to determine the process of wealth creation and, ultimately, the economic well-being of the nation as a whole. Firms and the government share certain objectives. Both are social organizations created to add value for their respective stakeholders, stockholders and voters respectively. In this effort, a minimum intervention would be to, at least, reduce the respective transaction costs in the economy. Poor performance of governments, namely a high debt to GDP ratio, tend to generate negative externalities for the economy (or higher transaction costs) that are reflected in macroeconomic variables such as output, involuntary unemployment, slowdown of profitability and capital creation and/or utilization, and a rise in inflation. In other words, the economic performance of the overall system depends significantly on the government involvement needed to reduce transaction costs given the characteristics of the economy. One of the major difficulties in the analysis of government involvement is the identification of variables that define the optimal size of the public sector relative to the private sector. Despite this difficulty, it is possible to evaluate the public action by looking at the overall economic performance of the system for a given period of time, and infer from this evaluation the nature of the relationship between the government and the economy.

If an economy has a positive acceleration of income then the optimal policy is a gradual reduction in the relative government involvement in order to avoid an excess of aggregate demand in the economy that may translate into higher prices, and a loss of the competitiveness on international markets. In the other hand, if the economy has a negative acceleration of private income, then the government may adopt an expansionary fiscal policy in order to support the aggregate demand in the economy and increase the utilization of factors of production in the economy. The above policy rule defines a counter-cyclical behavior in the optimal size of government intervention, in which the public sector systematically adjusts the aggregate supply and demand in the economy in order to avoid any potential source of income contraction. During a recession period, the economy is close to a Keynesian economy with unemployment of resources and real impact of government actions. At this point higher government expenditure may produce excess of demand in the economy because of the “inefficiencies” in the production side. This effect is associated with an aggregate demand larger than aggregate supply hence with an inflationary process. In an open economy, international accounts would start to present a negative balance.

In this sense, the government acts as a macro-coordinator of market forces (labor and capital, production efficiency and technology) trying to minimize dislocations in the economy. In the same sense, an excessive involvement of government (via increased spending) can be considered as another form of economic “bottleneck” or dislocation. According to the above theoretical aspects, the following facts are observed:

  1. Under an optimal government behavior, the allocation of government expenditure depends on the “state” of the economy. Particularly on the phase of the business cycle of the economy.
  2. It can be shown that the growth of government involvement is negatively related to the acceleration of the economy measured as the second time differential of growth of per capita income to time.
  3. The behavior proposed implies that the growth of government involvement is stronger, in periods of GDP deceleration than in acceleration periods.
  4. Economies with evident excess of government supply, e.g. central-planned economies, would present lower rates of growth than free market economies. See Guseh (1997) for empirical evidence.
  5. If economies tend to converge to a natural optimum rate of government size, then countries with relatively stable growth would tend to present, ceteris paribus, a low fluctuation in the degree of government involvement.

The above mentioned theoretical negative relationship between the growth of government involvement and the acceleration of the economy is being confirmed empirically in Psarouthakis et al. (2012) in a sample of selected OECD countries for the period 1970-2008. Periods of deceleration in per capita income are associated with a growth in government size and vice versa. If the reaction of the government is linear with respect to changes in the degree of economic growth, a sharp decline of economic output could support a sharp rise in government expenditures to bring the economy back to its efficient point. However, when the economy gains momentum and accelerates, the government should redefine its role.

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