Public expenditure, its size and composition, is one of the most important policy debates in economics and governance. According to the IMF, total government spending as a proportion of the global economy has been expanding, increasing from 29% of GDP in 2000 to 33% in 2019.
During the pandemic, when most countries experienced economic downturns of varying scale, governments continued to spend at unprecedented rates. Governments in advanced economies are spending an average of 6% of GDP on COVID-related response alone.
Even with the risk of ballooning deficits, governments continue to ramp up spending. But why? What is the impact of government spending on the economy?
How Does Public Expenditure Affect the Economy?
The budget is the most powerful policy instrument of any government. Without funding, a policy has no potency. In addition, governments are usually one of the biggest organizations in any country – in terms of both human and financial resources. Likewise, budget allocations for public services and programs are of public concern because they greatly impact on the lives of citizens. But in the context of the current economic downturn, the size of public sector expenditure is once again under the spotlight.
Effects of Public Spending on the Economy — the Good, the Bad and the Neutral
Governments accelerate spending during economic recessions due to the belief that state intervention can stabilize the economy. Keynesian economists, during an economic contraction, advocate increases in public spending as part of a menu of countercyclical fiscal policies that act against the direction of the business or economic cycle. Named after the British economist John Maynard Keynes, who advocated for governments’ more active role in the economy, Keynesian economics sees the necessity of public spending in counteracting the downward spiral of the market and in growing the economy.
This school of thought believes that government spending promotes economic growth since financing various spending programs stimulates aggregate demand and boosts economic growth. When governments construct infrastructure projects or spend on social services, there is a multiplier effect on aggregate demand by increasing employment, productivity and investments in the market.
Although using public spending as an economic stimulus is a common policy prescription, not all economic thinkers share the same perspective. Neoclassical economists caution governments against the negative effects of public spending. According to neoclassical economics, fiscal policies that promote huge public spending depress the economy because government expenditure crowds out private investment and consumption. Neoclassical economists argue that public investments discourage businesses from investing in the same sectors. This leads to lower private spending on education, health, transportation, and other goods and services where public spending is huge. Neoclassical economists see the private sector as the main driver of economic growth. Hence, governments should take a less active role in the economy and let corporations invest in market activities.
A third economic school of thought considers public spending as neither a positive nor a negative contributor to the economy. Instead, public spending is viewed as an effect of economic growth and not the other way around. Adolph Wagner, a German economist in the late 19th century, observed in a number of Western industrializing countries that growth in the economy also causes public sector expenditures to expand. Wagner linked the increase in government expenditure to the changing role of the government in the economy. He argued that the public sector has to adjust as a result of the pressures caused by social progress in society. With economic growth and prosperity comes an increase in demand for public services. Likewise, government functions have to be expanded to ensure that the market runs smoothly.
Shifting from Quantity to Quality of Public Spending
Regardless of which economic school of thought one subscribes to, it is undeniable that the quality of public spending is as important as the magnitude of spending. Considering the limited resources of governments, limiting inefficient spending, fighting corruption and enhancing the effectiveness of public expenditures have long been at the forefront of public financial management (PFM) reform road maps.
FreeBalance leverages its decades of experience working with governments around the world to help maximize the value-for-money of public spending. The Public Expenditure Management pillar of the FreeBalance Accountability Suite™ enables governments to manage all spending functions within a unified and integrated financial management system.
Regardless of the size of a government’s budget or the country’s economy, a well-run PFM system puts the citizens’ wellbeing at the forefront – sustainable spending that uplifts the lives of citizens.