The Government Budget Constraint: Something politicians don’t want you to think about.

We all see the political rhetoric especially around election season, and we all grow sick of it very quickly. The attack ads, smear campaigns, and “analytical” talking heads fill our media outlets, and our brains whether we want them to or not. Buzz words like tax cuts, financial assistance/relief for group x, and stimulus, are thrown around more often than Brett Farve returns to football from retirement. Most uninformed voters soak up this rhetoric and vote accordingly.

The politicians fail to recognize (or at least intentionally do not mention) the other side of the story: how will we pay for it? With over $14.3 trillion in national debt, this practice has gone on far too long.

One of the most fundamental principles of macroeconomics and therefore public policy is the Government Budget Constraint (GBC). As an interesting and somewhat frightening side note, I was not formally introduced to this principle in class until last week in my intermediate macro course (ECON 332 here at JMU). Even more frightening, my professor notified the class that he had only seen one macro textbook ever mention GBC. How could college graduates with a degree in economics never learn about one of the most fundamental principles of economics? Want the simple answer? Because the bias of most college professors doesn’t want them to. This law of economics demotes the government from its prior status of being the “all-powerful, able to do everything for everyone who wants/needs it and not having to worry about spending” body to an entity just like all of us. We all have to balance our finances, pay our debts, and earn money first in order to spend it.

So after all that, you probably want to know what GBC actually says.

The government budget constraint says that government expenditures must be identically equal to government revenues. (Simple enough right? That’s what I thought too. But why is it not taught in most macro books? Fishy, if you ask me.) Here’s the equation:

G + TR = T + BS + MC

G = government spending

TR = transfer payments (unemployment benefits, social security, etc.)

T = revenue from taxes

BS = revenue from bond sales

MC = revenue from money creation

All changes on the left side of the identity must be financed by a change on the right side. This law CANNOT be violated. It is impossible. So let’s look at a few applications of this law.

You want to build a new highway interchange in a metropolitan area with gridlock problems. This project is contracted at a cost of $200 billion. That means government spending is going to increase by $200 billion. According to GBC, we must finance an increase in G. We have 3 options: 1) Reduce TR 2) Increase T 3) Increase BS 4) Increase MC.

No one will want a reduction in unemployment benefits or social security, so that excludes Option 1. Tax hikes aren’t popular either, so there goes Option 2. This leaves Options 3 and 4 as the “only” alternatives. And this is what the government is doing (and doesn’t want you to think about it). Option 3 issues new government debt at fairly high interest to mostly foreign nations (China holds around 20% of our debt). Option 4 is basically printing money. That leads to inflation, and possibly hyperinflation if Option 4 is used often.

It is the constant use of Option 3 to pay for government spending since FDR that has left us with $14.3 trillion in debt. And the people to blame aren’t just Democrats or Republicans, it is all of us. We rely too much on the government to solve our problems and then don’t think about things like GBC that say that we will all have to pay for it one day.

Think about this the next time politicians campaign for more government projects or tax cuts. There is no such thing as a free lunch. Someone will eventually have to pay. And it looks like it’s going to be my generation.

Cheers.

~ by rfreeland on January 13, 2011.

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