Monday, 13 August 2012

Your Humble Guide to Public Finance I. - Introduction

If you've ever stumbled upon a blog writing about economics, you must have noticed words like 'fiscal','monetary', 'aggregate demand' and 'government stimulus', and reading more, fierce debates about 'the effectiveness of fiscal stimulus' or 'expansionary monetary policy'. Feeling confused?
There is no need. This series of posts wishes to explain what all the fierce debate is about – in short, public finance.

Readers notice: Starting this Monday, Schoolonomic launches a weekly series of connected posts, each of the series detailed to basic economic concepts and theories, explained in a - hopefully - fun and non-conventional way. Your Humble Guide to Public Finance is the first of these. Subscribe to the blog here to receive a flow of updates.

In a dream economy, there would be no need for public finance. Based on the model of free markets, private economic actors (men and groups with money) would provide all the goods and services you'd ever need, efficiently and equally – like security, health service, pensions, a protected environment and more.

Market failure

That is not the case, however. Due to various reasons – information asymmetry (imagine rival police stations which do not share criminal records), externalities (a coal plant's combustion products harming nearby corps), etc. –, not all services can be provided by private markets. This is called a market failure.
Consequently, there is a need for a non-profit, neutral entity to provide these public services for the individuals – and that is the government, which does this through the means of public finance.

Goals of public finance

The state's main goal is to correct these inconsistencies and maintain the efficiency of the free markets, namely by fighting resource allocation inefficiency (For example, in the 1880s Italy, 20% of landowners held 80% of land), income allocation inefficiency (In contemporary US, the top 1% of the population holds 18% of income) and keeping macroeconomic stability (Keeping the goals of full employment, constant economic growth, price stability, and balance of state budget).

Methods of public finance

The state can do this two ways – either by regulation (telling market actors what they can and can not do, the collection of these regulations is the law), or macroeconomic stabilisation policies. Regulation is done by jurists and economists, while macroeconomic policies are set by politicians and economists. The latter is what all the debate is about – so let's explore it further.  

Macroeconomic stabilisation policies

The economy constantly needs stabilising – and that is what these policies do. There are two types of them, fiscal policy (controlling the spending of the state) and monetary policy (controlling the spending of the markets, a.k.a the money supply). These two are the ones that most of the debate is about, with economists generally favouring one or the other, and they will be covered in separate follow-up posts as part of this series.

Government failure

Finally, we must also mention – and us, Central Europeans know this from bitter experience – that the state is not perfect, either. When the state makes inefficiency even worse than it was without intervention, a government failure occurs. These are consequently worse than market failures, and finding the careful balance between government and market failures is another big question of macroeconomics.

Follow up on this post to learn about monetary and fiscal policy – and meanwhile, feel free to leave a comment.

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