The unintended consequences of the debt

Werner, R.A. (2008) The unintended consequences of the debt (Discussion Papers in Centre for Banking, Finance and Sustainable Development, CBFSD-08-02) Southampton, UK. University of Southampton

Abstract

Currently governments worldwide are embarking on some of the largest fiscal expenditure programmes witnessed in peacetime history. The fiscal expenditure is considered necessary to support the economy and prevent a serious recession. Fiscal expenditure will be used to purchase equity in banks and non-performing assets, compensate depositor losses and to engage in active government investment and spending programmes.
It is the purpose of this study to examine the overall impact, including the unintended consequences, of the substantial increase in fiscal expenditure. The most relevant recent experience in similar circumstances is that of Japan in the 1990s: a paralysed banking system required public fund injections and the government implemented what until then was one of the largest peacetime fiscal stimulation programmes on record. This resulted in sizeable public debt. However, the effect of fiscal policy has been disappointing. In this paper, the explanations provided by the literature and their unsatisfactory empirical record are first reviewed. An alternative explanation, derived from early Keynesian models on the ineffectiveness of fiscal policy is presented in the form of a modified Fisher-equation, which incorporates the recent findings in the credit view literature. The model postulates complete quantity crowding out. It is subject to empirical tests, which were supportive. The present banking bailout packages are thus likely to result in a reduction in private sector demand. However, it is also shown that by changing the funding strategy, complete crowding out can be avoided and a positive net effect produced.

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