Vimothy had a great comment here which directly relates to the importance of the accounting.
“ I came across a paper in this vein while trawling through Google Scholar recently. The paper is Cebula (1995), “The impact of federal government budget deficits on economic growth in the US”. I haven’t had chance to read it properly yet, but from the conclusion:
The primary conclusions regarding the impact of fiscal policy variables on per capita real economic growth are:
a) federal government purchases appear to exercise a negligible impact on economic growth;
b) the federal budget deficit acts to significantly reduce the economic growth rate;
c) a higher maximum level of federal government personal income tax rates significantly reduces the economic growth rate; and
d) a higher maximum level of federal corporate income tax rates significantly reduces the economic growth rate.
Richard Cebula probably did some serious and diligent research. He probably used some very credible and reasonable math to come to the conclusion he did.
But we can’t trust the conclusion at all. Here is an excerpt from the Godley paper:
“There is an obvious shortcoming to the original Christ formula in that it only applies to a closed economy. This deficit is easily remedied by adding exports ot the governmetn expenditure (injections) and imports to taxes (leakages). So the open-economy version of the Christ concept of fiscal stance is given by government outlays plus exports divided by the average tax rate plus the open-economy counterpary of the tax rate, namely , the share of income that leaks abroad. We call this ratio the augmented fiscal stance” (AFS), which now includes the effect of net export demand with the government’s net injections.”
Godley then constructs a time series which looks very much like NGDP out of the AFS. Of course, it’s slightly off. So he does a bit of reasearch of why it is off, and it turns out the errors are nearly exactly mirrored by the level of private (non-financial) lending.
In short, Godley demolishes Cebula, and has a more coherent and simpler explanation on how and why he is correct.
This isn’t a mystery. It’s just a matter of using the accounting and sector balances correctly. Cebula probably did a good job, he’s just not aware of how the entire economy fits together. His conclusions are wrong because he didn’t follow the accounting which matters to GDP.
Does government spending help or hurt the economy? Well, it depends. But you can’t tell from looking at government spending vs. economic activity as a single variable regression. It’s like trying to measure the amount of water in a leaky bucket under an open water spigot.