Pump Priming

Let's go back in time to the early 30s when the prevailing view amongst the public was that free market capitalism had failed and that some other system was needed to replace it. At Cambridge University, in England a new school of thought was emerging, which still carries weight today. Every now and then the world hands us a genius, whether it be in science, medicine, engineering, whatever, these people look at the prevailing way of doing things and come up with better ways, somehow they push the boundaries of reasoning to a third dimension.

For economists, John Maynard Keynes, was their genius. Like so many other economist of his generation, Keynes found the great depression both a paradox and a great challenge. It was a paradox because it seemed to contradict some of the fundamentals that economist took for granted.

Keynes rose to the challenge by writing a complex sophisticated hypotheses which not only highlighted the challenge but also explained a way out. It was a way to end the great depression and end similar episodes in the future.

Keynes theory was against the prevailing school of thought at that time. The crux of his theory is that what happened to the quantity of money didn't matter, what really mattered was a particular category of spending, in economist jargon it is referred to as autonomous spending.

What type of spending is that? Autonomous spending refers to investment by business enterprises in building factories, adding to the number of machines, adding to inventory. It is also known as Capital expenditures (CAPEX or capex). Autonomous spending can also include spending by individuals to build houses, purchase autos etc.

Finally, autonomous spending also refers to deficit spending, government spending. So in a recession, in a downward business cycle when private investment dries up, the government steps in to make up for the shortfall in investment.

The theory of pump priming was born.

The Definition of pump priming is “the action taken to stimulate an economy, usually during a recessionary period, through government spending, and interest rate and tax reductions. The term "pump priming" is derived from the operation of older pumps; a suction valve had to be primed with water so that the pump would function properly. As with these pumps, pump priming assumes that the economy must be primed to function properly once again. In this regard, government spending is assumed to stimulate private spending, which in turn should lead to economic expansion.”

In other words, the idea is to crank start the economy back to life by running public deficits, which implies financing public spending through debt rather than taxation.

For politicians this was music to their ears, since now they could spend money and buy themselves out of trouble. Moreover, they didn't have to tax their citizens to pay for it. 

At last came a scientific theory offered under the most responsible of auspices that justified what politicians wanted to do all along.

So it is no surprise that government spending has exploded ever since deficit spending has become the order of the day.

In the UK, public deficit is rising not falling. “The latest public sector borrowing data show that the UK budget deficit is widening once more. Despite a series of accounting adjustments which obscure the true picture, it is clear that the underlying trend is also towards rising, not falling deficits,” Prime Policy Research in Macroeconomics.

As reported in the Guardian September 23, weak tax receipts have pushed borrowing to 11.6 billion pounds in August excluding bank bailouts, 700 million pounds more than a year earlier, according to the Office For National Statistics . Borrowing in the fiscal year so far, from April to August, was 45.5 billion pounds , 2.6 billion pounds higher than the same period last year.

Economists said the poor start to the year had put at risk the Treasury’s official target of reducing borrowing to 95.5 billion pounds in 2014-15 from 105.8 billion pounds in 2013-14. Howard Archer, chief UK economist at IHS Global Insight, said Osborne had “a mighty tough job” on his hands to meet the target.

In the US, national debt is fast approaching 18 trillion US dollars, its largest in history. The US debt clock keeps accumulating debt. Source: http://www.usdebtclock.org/

What about the EU's deficit, well that is life in the red too. The main business headline story in Europe now is about France's “serious non-compliance” with tightened EU deficit rules. As reported in the Wall Street Journal. The European Union is likely to reject France’s 2015 budget, according to European officials, setting up a clash that would be the biggest test yet of new powers for Brussels that were designed to prevent a repeat of the Eurozone’s sovereign-debt crisis. French Finance Minister Michel Sapin said last month that his country would run a budget deficit of 4.3% of gross domestic product next year—far from the 3% deficit it had previously pledged. Disregarding the effects of the weak economy, the government’s planned cost cuts would amount to just 0.2% of GDP, falling short of cuts worth 0.8% that it had agreed upon with Brussels.

Italy might be joining France's deficit showdown with Brussels (Germany) since Italy will also miss budget targets.

But all these hefty government deficits, particularly in the peripheral states of the bloc have pushed up borrowing costs. Interest rates on bonds have risen and that has made private investment (capex) more expensive.

It's a conundrum. If Keynes were alive today what would he suggest.