Before, during and after this month’s budget, Treasurer Joe Hockey sounded dire warnings about Australia’s “budget emergency”. Amidst this fear-mongering, it was a pleasant relief to come across a dissenting view. In a recent interview on 2SER Dr Stephanie Kelton (Department of Economics at the University of Missouri in Kansas City) argued that the government budget is very different from a household budget, however appealing that analogy might be. Governments like the Australian government, with its own free-floating currency can spend more than they take in taxation without worrying about running out of money. While the economy is weak, the government can comfortably run a deficit. The constraint to worry about is the risk of  inflation, which means curbing spending once the economy heats up.

I posted a link to Facebook, and immediately drew comment from a more conservatively libertarian-minded friend: “of course a deficit is a bad thing!”. Pressed for an explanation, he argued that government spending was inefficient and “crowded out” more productive private sector investment. This did not surprise me. Deep down, the primary concern of many fiscal conservatives is government spending itself, not a deficit. This is easy to test: ask them whether they would be happy to see the deficit closed by increased taxes rather than decreased spending. The answer is generally no, and helps explain why so many more traditional conservatives are horrified by the prospect of the Coalition’s planned tax on higher income earners….sorry, “deficit levy”.

From there, the debate deteriorated. North Korea was compared to South Korea as evidence of the proposition that government spending was harmful, while a left-leaning supporter asked whether this meant Somalia’s economy should be preferred to Sweden’s. Perhaps foolishly, I proffered a link to an academic paper (on the website of that bastion of left-wing thought, the St.Louis Fed) which presented a theoretical argument to the “crowding out” thesis. My sparring partner then rightly asked whether the thread was simply becoming a rehash of the decades old Keynes vs Hayek feud, a feud best illustrated by Planet Money’s inimitable music video.

Macroeconomic theory was never going to get us anywhere (as I should have known only too well). Instead, the answer lay in the data, with more sensible examples than North Korea and Somalia. Aiming to keep the process fair, avoiding the perils of mining data until I found an answer that suited me, here was my proposal:

I’m going to grab a broad cross-section of countries over a range of years and compare a measure of government expenditure (as % of GDP to be comparable across countries) to a measure of economic success (I’m thinking GDP per capita in constant prices).

If indeed government spending is inherently bad for an economy, we should see a negative correlation: more spending, weaker economy and vice versa. My own expectation was to see no real relationship at all. In a period of economic weakness, I do think that government spending can provide an important stimulus, but I do not think that overall government spending is inherently good or bad.

The chart below illustrates the relationship for 32 countries taken from the IMF’s data eLibrary. To eliminate short-term cyclical effects, government spending and GDP per capita (in US$ converted using purchasing power-parity) was averaged over the period 2002-2012.

The countries in this IMF data set are all relatively wealthy, with stable political structures and institutions. All but one is classified as a “democracy” by the Polity Project (the exception is Singapore, which is classified as an “anocracy” due to an assessment of a high autocracy rating). This helps to eliminate more extreme structural variances between the countries in the study, providing a better test of the impact of government spending. Even so, there are two outliers in this data set. Luxembourg has by far the highest GDP per capita and Mexico quite low GDP per capita, with the lowest rate of government spending.

The chart below removes these outliers. There is no clear pattern to the data. There is no doubt that government spending can be well-directed or wasted, but for me this chart convincingly debunks a simple hypothesis that overall government spending is necessarily bad for the economy.

Now look for the cross (+) on the chart: it is Australia (IMF does not include data for New Zealand and we are the sole representative of Oceania). Despite Hockey’s concerns about a budget emergency, Australia is a wealthy country with a relatively low rate of government spending. Among these 30 countries, only Switzerland and South Korea spend less. These figures are long run averages, so perhaps the “age of entitlement” has pushed up spending in recent years? Hardly. Spending for 2012 was 35.7% compared to the 2002-2012 average of 35.3%. The shift in the balance of government spending from surplus to deficit is the result of declining taxation revenues rather than increased spending. Mining tax anyone?