5.) The following quotation is from Bloomberg. Com and is in turn based on extra

Question

5.) The following quotation is from Bloomberg. Com and is in turn based on extracts from a paper by Michael Spence, Is the approach to budget deficits briefly outlined here more “Keynesian,” more “Crowding Out” or more “Supply Side” in tone?

Michael Spence: Many governments nowadays are accumulating debt in order to buttress public or private consumption. This approach, if overused, can amount to borrowing future demand; in that case, it is clearly unsustainable. But, if used as a transitional measure to help jump-start an economy or to provide a buffer from negative demand shocks, such efforts can be highly beneficial…. In an environment of low long-term interest rates and deficient short-term aggregate demand (which means there is little risk of crowding out the private sector), it is a mistake not to relax fiscal constraints for investment. In fact, the right kind of public investment would probably spur more private-sector investment. Identifying such investment is where today’s debt debate should be.

Explanation / Answer

Michael Spence: Many governments nowadays are accumulating debt in order to buttress public or private consumption. This approach, if overused, can amount to borrowing future demand; in that case, it is clearly unsustainable. But, if used as a transitional measure to help jump-start an economy or to provide a buffer from negative demand shocks, such efforts can be highly beneficial…. In an environment of low long-term interest rates and deficient short-term aggregate demand (which means there is little risk of crowding out the private sector), it is a mistake not to relax fiscal constraints for investment. In fact, the right kind of public investment would probably spur more private-sector investment. Identifying such investment is where today’s debt debate should be.

Answer :

The Tone of the article appears to be more “Keynesian “than anything else.

Debt is indeed likely to affect future consumption, because this is the observable fact that many government activities today on a global perspective involve borrowing. What Debt actually does is to pump additional demand into the Economy through the mechanism of credit creation. However, if the repaying capacity becomes a question mark over periods of time, more debt can cause a complete collapse of the level of aggregate supply.

Here the author advocates the use of pumping money into the economy during a transitional phase, where the Economy has faced external shocks that affects the investment and expectation climate. This is exactly what Mr. Keynes advocated during the great depression of the 1930’s.

One of the effects of such additional government spending is the “crowding –out effect” which Keynes pointed out. If the government invests in areas where the private sector is indeed capable of doing the job efficiently, the later will withhold investments as government activity restricts the returns of private enterprise. In such a situation, instead of the desired increase in aggregate demand and supply levels, there will be fall. Keynes advocated, investment in infrastructure projects which are large and which have long gestation periods. These require massive funds which can be financed by debt. In addition to that, it enables private sector to take up investment which are complementary to the government projects. The key to success of measures like quantitative easing and “pump-priming” is to identify non-conflict areas of investment for both government and private sectors, so that they become jointly resulting in creating of aggregate demand rather than produce negative impact on one another.

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