Government's Costs When Resources Are Idle
The alternatives individuals lose when government acquires more resources determine who really pays for government. Suppose that our economy is in a depression with massive unemployment of land, labor, and capital. Government might boost output by drafting (confiscating) idle resources, or it could secure money to pay for them through taxes, growth of the monetary base, or borrowing. If these resources would have been completely unproductive in the absence of government action, the opportunity costs of the extra output are zero; the additional government services would not cost anyone anything.
The production possibilities frontier in Figure 3 allows us to examine an increase in government spending and the resulting induced consumption. If many resources are idle and the economy is initially at point a, raising government spending from G0 to G1 closes the recessionary gap in this idealized case. Consumption induced through the Keynesian multiplier process will drive total consumption from C0 to C1 This completes closure of the GDP gap, so the path to full employment is aÒ bÒ c.
Figure 3 The Costs of Government: Crowding Out
The general problem of government spending crowding out private activity is illustrated in this figure. Beginning from a point of considerable unemployment (a), government can increase spending from G0 to G1 new consumption equal to C1 - C0 will be induced through the multiplier. The opportunity costs of such increases are the value of the private uses to which the DG would have been put, including the leisure forgone by the newly employed. Once the economy has achieved full employment (point c), increased government spending to G2 (point d) necessarily causes a reduction in private spending from C1 - C0. Critics of the growth of government relative to private activity view expanded government as an inefficient block to investment that would foster healthy long-run economic growth.
This seems to be an exception to the TINSTAAFL rule that "There is no such thing as a free lunch." It is not. Few resources are ever totally without valuable uses "in the absence of government action." For example, idle labor produces leisure; most of us prefer no work to work with no pay. To induce idle labor to work voluntarily, government must pay a wage that offsets the value of the leisure lost in producing the extra output; increases in employment come at the cost of forgone leisure.
Government might use direct confiscation to impose on the owners of idle resources the full cost of providing extra government goods; drafting unemployed labor for armies of conservation workers or highway repair crews would be examples. If tax revenues are used to pay the owners of the newly employed resources, the burden falls largely on taxpayers. If government creates money to pay for these resources, then the higher incomes of the owners of previously idle resources may be partially offset by inflationary reductions in the purchasing power of other citizens.
Suppose the government issues bonds to buy the resources used to produce extra government goods. The consequences are illustrated in Figure 4. When more Treasury bonds are issued, raising the supply of bonds from S0 to S1 (in Panel A), bond prices fall. The falling price of bonds causes interest rates to climb from i0 to i1(from point a to point b in Panel B). Successful borrowers pay higher interest rates and some private investment is crowded out. This dampens the growth in Aggregate Demand, which rises only from AD0 to AD1 ---not to---AD2 in Panel C, as would occur without crowding out.
Figure 4 The Crowding-Out Effect: Investment
Increased sales of bonds by the government increase the supply of bonds in the bond market in Panel A from S0 to S1 resulting in the price of bonds falling and interest rates rising. As interest rates rise from i0 to i1 in Panel B, investment falls from I0 to I1 diminishing the increase in Aggregate Demand by AD2 - AD1 (Panel C). Thus, the growth in Aggregate Income is hindered because of crowding out.
Borrowers and potential borrowers pay the short-run burden of more government spending when a budget deficit is financed by sales of new government bonds. Figure 5 illustrates how real interest rates jumped with the record deficits of the late 1970s and early 1980s and then fell when deficits declined temporarily in the late 1980s. In the longer run, consumers will pay higher prices because investment shrinks, adding less to the stock of capital. With less capital growth, real wages and output will not rise as fast.
Figure 5 Real Interest Rates and Budget Deficits as Percentages of GDP
When budget deficits have grown relative to our GDP, real interest rates (money rates of interest adjusted for inflation) have also tended to rise.
Source: Economic Report of the President, 1994.
When the economy is at less than full employment, the degree of crowding out depends in part on the interest sensitivity of demands for loans by investors and consumers. During severe recessions, induced Keynesian growth of income can overwhelm any losses in purchasing power caused by crowding out. Crowding out restricts the power of the Keynesian multiplier process to boost real income---especially in a fully employed economy.
Government's Costs During Full Employment
We have assumed that some resources were idle when government purchases grew. Expanded government spending is a standard Keynesian prescription when the economy is in a slump. Who pays for government growth if the economy is fully employed? When all resources are efficiently and fully employed, any increase in government purchases necessitates declines in either private consumption, investment, or net exports. Refer back to Figure 3. If the economy began at point c, boosting government purchases from G1 to G2 would move the economy to point d and shrink the sum of private spending (consumption and investment) from C1+ I0 to C0+ I0.
Government causes crowding out through tax hikes, confiscation, inflation, or higher interest rates. Excessive reliance on any single mechanism may cause political turmoil and significantly reduce some resource owners' incentives to be productive; therefore, government commonly chooses a mix of these ways to cover new government spending.
For example, President Johnson realized that the voting public would reject tax increases to pay for both the war in Vietnam and the "War on Poverty" in the late 1960s. In spite of advice from his Council of Economic Advisors that tax increases were necessary to avoid inflationary pressures, President Johnson chose to run budgetary deficits. What choices were available? Because G - T = DB + DMB , the alternatives were either to borrow the money or print it.
The Treasury initially covered the deficits by issuing new bonds. A large proportion of the loanable funds available would have been absorbed if these bonds had been purchased solely by the public; interest rates would have soared, leaving little money available for private investment. The Federal Reserve Board elected to buy many of the new bonds issued by the Treasury. This expanded the monetary base and caused the money supply to rise, preventing the full brunt of financing the Vietnam War from falling exclusively on private investment. Inflation caused prices and nominal income to swell, so total tax revenues increased.
The overall result was that crowding out spread the costs of the War on Poverty and the Vietnam War across four groups: (a) investors, who paid higher interest rates; (b) consumers, who paid higher prices; (c) taxpayers, who paid higher taxes; and (d) Selective Service draftees---being drafted was a form of confiscation of labor to pay for the Vietnam War. This example correctly suggests that the mix of policies government uses to finance its spending has important implications for the distribution of income; each method of reducing private activity imposes burdens on different groups.