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The classical model is mandatory reading for most macroeconomics classes. I teach it because I have to, but I teach it in a way that the caveats and assumptions are front and center. It's apparent to me that the profession of economics perhaps has not drawn enough attention to those assumptions (or perhaps exacerbated the view that they are unimportant), since it seems a significant chunk of the American public is hyper-concerned about the debt, when perhaps such concern is not warranted compared to all our other problems du jour.

The classical economic model is a ‘pot of gold’ model, where an economy has a certain fixed amount of resources by which it creates productive capacity. The classical model assumes markets are perfect in the sense that there is 100% utilization of resources at market determined costs of those resources. This means that at market given wage and interest rates, we have ‘full employment’ (not counting a certain amount of unemployment that may exist just due normal movements between jobs, etc.) of both labor and physical capital (buildings are staffed, machines are manned, etc.).

So, now, in this classical world the government comes in to an economy that is already using 100% of the resources and says, “I want to spend $1B more and give everyone healthcare.” In our classical world, there are no more resources to devote to this new policy so the government has to take it from the existing ‘pot of gold’. In other words, they have to take resources that are currently being (presumably productively) used in the private sector (by businesses). In this world, at a minimum, the healthcare spending does nothing for growing the economy and at worst it does one of two things (or some combination): (1) severely harms economic growth by taking some of the existing ‘gold’ necessary for the private sector to do its thing – either by increasing taxes or some other mechanism, and/or (2) in the case where the government starts up the printing press and starts manually artificially creating more 'gold' to fund its spending, inflation will ensue. Neither of these is pretty. In either case, the classical model further assumes that when the government spends money, 0% helps economic growth, while, when businesses spend money, 100% of that spending helps economic growth.

But, the real world doesn’t look anything like the above classical ‘pot of gold’ scenario. In the real world, economies are subject to bouts of booms and busts for varying reasons: sometimes there’s an asset bubble that bursts (housing, stocks), sometimes there is an oil crisis that causes prices of all business activity to raise thereby stunting growth, and sometimes there is a large degree of uncertainty and other more ‘soft’ things that create pessimism in markets – reducing the revenues businesses need to operate and grow effectively.

In the real world, therefore, economies often are not operating at ‘full employment’. Perhaps a significant chunk of the labor force is out of work. Perhaps perfectly usable buildings are sitting empty for months. Perhaps banks aren’t lending and perhaps businesses are just sitting unproductively on their assets. This seems like common sense reality, but it’s this common sense fact that changes the outcome of the government wanting to “spend $1B and give everyone healthcare.” Now, the government can enter into a deficit situation not by taking from the private sector but simply by starting up the printing press and creating more funds. They could do this in the classical world too but unlike the classical world this will not result in inflation because the increased spending/demand from the new government policy simply soaks up some of the already underutilized resources (it results in workers being hired to enact the policy and carry it out, and it results in certain capital being used that might otherwise be sitting idle). In this kind of environment, there is enough 'supply' of productive capacity to fill the 'demand' for this new government program, and no inflation needs to occur.

But what if this healthcare policy were enacted in a ‘normal’ economic time – not on the tail-end of a recession? Even if we assume that 'normal' means we have 100% full employment (which is itself debatable), classical economics falls apart. The key here is the unfortunate assumption classical economics often makes about the difference between when the government spends and when businesses spend. Recall from above, in the classical model, when the government spends money, 0% helps economic growth, while, when businesses spend money, 100% of that spending helps economic growth. Most folks recognize that assumption to be patently false in the real world. When BP invests millions of dollars in off-shore oil rigging that eventually causes multi-billion dollar environmental catastrophes, or when Chinese businesses invest money in making tires for export to the US that subsequent explode while us Americans are barreling down the road – not all of that sounds particularly productive: quite the contrary actually. Conversely, when the government spends money on educational infrastructure, transportation and logistics infrastructure, or perhaps even providing some certainty for millions of Americans regarding their healthcare…. Some of that is likely very productive and adds to the economic capacity of the United States. The point here is that some government spending actually increases the size of the pot. And to the degree that the potential for that growth that might not normally occur in the private market is probable compared to the potential for the policy to cause inflation – even in ‘normal’ economic times that spending policy may be worth it. In today's environment, the potential of Obamacare to increase economic growth is debatable. But the potential for it to cause inflation is almost non-existent because (1) it is of relatively small cost in the grand scheme of our economy, and (2) if the markets thought significant inflation was on the horizon, interest rates on non-government backed securities would be pressured to increase as potential lenders would demand a higher rate of return to cover the higher future prices - but this is not happening at all today.

What this means for our present political debate over the government debt is that there is a fundamentally simplistic worldview that many Republicans have, that is largely based on the overly simple classical model of economics: the idea that when the government goes more into debt, it takes existing resources from the private sector and kills economic growth. It ignores the reality that in fact, the debt is much more a by-product of economic growth and the cycles of booms and busts as supposed to the other way around. And that in fact, sometimes, the government can have positive effects on economic growth albeit with a substantial upfront cost. Most folks call that an 'investment' in the future.

Read More... [Source: Reviving Economics]

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