BEE Partner, South Africa Economy Watch

Suppose, for example, that the GDP growth rate exceeds the interest rate by five percentage points. Then the steady-state deficit-to-GDP ratio will be 5 per cent of the debt-to-GDP ratio. If the debt-to-GDP ratio is at, for example, 60 per cent, then the primary deficit-to-GDP ratio can be permanently maintained at 3 per cent. Incidentally, these figures are the same as those stipulated in the European Union Maastricht Treaty as ‘convergence criteria’ for debt and deficit. Note that if the GDP growth rate exceeds the interest rate by five percentage points, then no less than one-fifth of the public sector in our ’small government‘ example, and one-tenth of the ‘big government‘ example, can be permanently financed by allowing the government debt to grow continuously. Taxpayers would be relieved accordingly.

Once we acknowledge the feasibility of substituting a permanently growing public debt for taxation, we have opened up a Pandora’s box. Whereas the figures in the above example indicate a substantial, albeit limited, contribution to the financing of public spending, other figures will give other results. In principle, there is nothing that prevents us from imagining the full financing of all government spending by simply allowing the public debt to grow and thus levying no taxes. We have reached the nexus of Functional Finance where debt dynamics and Chartalism meet to answer Lynn Turgeon’s pertinent question: Why should people be taxed at all?

Let us retail/ the assumption of a five percentage-point excess of the GDP growth rate over the interest rate. Suppose now that the debt-to-GDP ratio could be raised to 300 per cent. The arithmetic then yields a primary deficitto-GDP ratio ofl 5 per cent, which is sufficient to finance the whole of the `small government,’ and half of the ‘big government.’ In order to deficit finance the entire ‘big government,’ the debt-to-GDP ratio must be boosted to an astronomic 600 per cent.

The key to accomplishing the substitution of debt growth for tax finance lies in keeping interest rates below the GDP growth rate. So long as the interest rates exceed the GDP growth rate, the government debt will work the other way round, as a drag on the private sector and the taxpayers. The required low- interest policy may not be easy to bring about and even more difficult to sustain, particularly in today’s institutional setting with internationally open financial markets. At the very least, a unilateral move towards lower interest rates presupposes the maintenance of a flexible exchange rate regime.

The analysis of the practical difficulties of these policies and the possible need for institutional reform. Our purpose here is merely to bring to the reader’s attention the core principle of substituting debt growth for taxation, which should be a hobby horse of Functional Finance. The larger the excess of GDP growth over the interest rate, the greater the ‘leverage’ of government debt increases into primary deficits, and the more taxation can be replaced with deficits and debt growth. The difference of five percentage points chosen in our examples was not picked out of a hat. Modern economies seem to be able to grow, in real terms, by at least 3-4 per cent per annum, and it does not seem unreasonable to assume that real interest rates can be brought down, by appropriate monetary policies, to some 1-2 per cent below zero. The difference implied lies in the region of four-to-six percentage points. Thus the 5 per cent ‘lever’ suggested in our examples does seem to lie within reach for practical policy.

The Wealth-to-Spending Turnover Rate Revisited

This reductio ad absurdum brings us right back to the relations depicted in the graphs of Figure 14.1 that show consistency requirements in terms of the private wealth-to-spending turnover rate in order to finance all government expenditure by debt growth instead of taxation. Full deficit financing of ‘big government‘ does not seem practicable. The graph does not even cover the point of intersection between the ‘big government‘ curve and the required debt-to-GDP ratio of 600 per cent. In order to accomplish such a gigantic debtto-GDP ratio, the private wealth-to-spending turnover rate would have to be lowered to less than 0.08, meaning that the private sector on average would turn over its wealth into effective demand once every twelfth year. However the idea of deficit financing the ’small government‘ does appear somewhat less far-fetched. The `small government‘ curve crosses the required 300 per cent debt-to-GDP ratio at a private wealth-to-spending turnover rate of about 0.13, corresponding to the private sector revolving their wealth at an average pace of once every eighth year.

These different wealth-to-spending turnover rates may say very little until we get some idea about the actual wealth-to-spending turnover rates in the real economies of today. As in the case of the capital—output ratio, there is some variation, but there nevertheless appears to be a tendency for this rate to hover around the 0.20 level. Which puts in perspective the needed lowering to less than 0.08 in the ‘big government‘ case. It just does not seem realistic to bring down the turnover rate by nearly two-thirds. The turnover rate reduction required in the ’small government‘ case (by one-third, from roughly 0.20 to 0.13) is also quite large, but much smaller and more manageable than the ‘big government‘ case.

Thus the whole matter of permanent deficit financing of government spending revolves around one particular parameter: the private-sector wealthto-spending turnover rate u.¹¹ Unless u can be brought down to a sufficiently low level, there will be no room for the public debt needed to yield the required deficits. This suggests that the future efforts of Functional Financiers might best be directed to the question of how this turnover rate can be affected and regulated by means of policy measures.

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