Growing the economy without debt: Possibility or wishful thinking?

Growing the economy without debt: Possibility or wishful thinking?

During the Greek debt crisis, Greek and European politicians have often referred to an “alternative” public policy mix that could enhance growth and reduce debt accumulation. For instance, among many others, Greek Prime Minister Alexis Tsipras in a press conference with German Chancellor Angela Merkel in May 2015 said that “Greece needs a new policy mix.”

Although politicians long ago recognized the need for a different policy mix, it has not been clearly defined and, in turn, has not been implemented. At the same time, many scientific articles propose policy reforms regarding the optimal mix of public expenditures. In particular, recently, it has been proved that an intertemporal change in the allocation of existing government revenues in favor of the more productive sectors can boost growth without the need for more debt, higher taxes or spending cuts. The idea there is simple. The relative productivity of public services among different sectors changes over time. Thus, due to technological progress, some sectors become redundant and some more productive. This generates an opportunity to promote those sectors that are more productive using the current government revenues with mutual benefits to the others.

However, a careful inspection of the data shows that the relative share of government expenditures across sectors changes slightly over time. For example, data from Greek national accounts reveal that the GDP share of public expenses that go toward education is almost constant at 4 percent with small fluctuations. Meanwhile, the productivity of education has increased, for example, due to the introduction of computers and electronic learning. Similarly, the GDP share of public expenses in other sectors of the economy that have become relatively less productive has remained constant. This means that politicians have failed to take into account intertemporal changes in relative productivity.

Yet a reallocation of resources across public sectors may entail substantive social benefits. Consider the following numerical example: Assume that in year A public revenues are 10 euros equally distributed between two sectors, education and health. Further assume that with 5 euros spent on doctors we can cure 10 people and with the remaining 5 euros spent on education we can educate 10 doctors. In this case, the productivity of both sectors is 10/5=2 (with every euro we can cure 2 patients or educate 2 doctors). Let’s assume that in the following year B, due to advancements in technology,1 public revenues increase to 12 euros and productivity in education increases to 3 2 while it remains at 2 in the health sector. If we follow the previous rule for the allocation of resources, with 6 euros spent on doctors we are going to cure 12 people (6*2) and with the remaining 6 euros in education we can educate 18 doctors (6*3). However, if we take into account this change in productivity and, instead of allocating 50 percent of resources to each sector, we give the same amount to doctors as we did in year A, i.e. 5 euros, then we are going to cure 10 people, while with the remaining 7 euros spent on education we can educate 21 (7*3) doctors. In that case, with 21 doctors we could cure 42 people in the following period.

Although this is an artificial and rather simplistic example, it does make a clear point. Relative productivity in economies changes over time. Private markets reallocate resources automatically via price mechanisms, but governments have to explicitly take into account these changes and then deliberately channel public revenues toward the more productive sectors, thus fostering growth. Also, as production increases (e.g. more cured people per doctor), governments will not have to raise public debt in order to finance public expenditures.

This is an illustration of how to increase production in an economy using existing resources and taking into account advances in technology and changes in productivity. But what are the potential problems of changing the policy mix and what are the related solutions? Why do governments not take on board changes in relative productivity when they allocate government spending?

First, in the absence of economic growth, the reallocation of resources generates winners and losers (i.e. through expenditure transfers from the less productive to the more productive sectors). This situation will certainly bring to the surface political obstacles, since the “unproductive” sector will have a clear incentive to resist change. However, this is a short-term problem. As the economy grows, those who lose out from the reforms can be partially compensated from the growth dividend generated by sounder allocation of resources.

Second, opportunistic politicians typically care more about their constituents than maximizing social welfare (e.g. certain professional groups are attached to certain political parties). Indeed, during the last few decades Greece has suffered much from political clientelism and rent-seeking activities. But the good news is that this problem can be resolved if governments allocate public revenues to the productive sectors in the first years of their electoral cycle so as to minimize political costs and/or compensate the unproductive sectors by the end of the political cycle.

Last, we have to note that none of those two problems is likely to arise if the economy is growing because, in that case, the government can intertemporally reallocate only the fraction of revenues that result from higher economic growth (e.g. in the above example, reallocate only the 2 units that come from better technologies).

To sum up, even in the worst-case scenario of no growth and short-run costs in the unproductive sectors, governments can enhance growth and increase overall income by reallocating existing revenues, thus creating aggregate benefits across all sectors of the economy. This new policy mix only requires changes in the composition of current spending, which means that it is tax-neutral and does not add to the accumulation of public debt. Even better, such a policy strategy does not downsize the public sector, which means that is ideologically neutral and therefore can be supported by all political parties irrespective of their ideological predilections. The newly elected Greek government has to grasp the opportunity to proceed with such measures as soon as possible before the next elections for the mutual benefits of all sectors.

1. The change in productivity has its origins in the demographic change we observe in the data. I use here as an example the technological change just for simplification.

2. For example, better technology can imply better laboratories for the education of doctors.

Dr Evangelos Dioikitopoulos is Assistant Professor of Economics at King’s College London.

Also contributed to this report:

Dr Christos Koutsampelas, a Researcher at the University of Cyprus.

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