The effect of public expenditure on economic growth is a tricky one. One could argue that the public sector drives economic activity through taxation and regulation. This argument has some force. However, I think it misses the mark. It tends to focus too much on what governments do and the effect that they have upon economic growth. By looking mainly at the effects that governments have on private activity, it is missing the mark.
For starters, the government's direct action programs tend to divert resources to private sector firms. But this is not necessarily because the government wants to increase its own strength. It is not because it wishes to increase employment opportunities. It is also not because it wants to stimulate demand in the economy.
The real function of the state in economic thought is not that of a regulator of private activity, but as a provider of basic goods and services to the market. It does so for the common good. It is not true that if the government gets something it wants, private sector firms will necessarily respond. If the government provides something essential to the market, private sector firms will be forced to increase their output to match or even surpass the new demand created by the government intervention. In short, the government is not a lender, but simply an owner of the economy.
It follows that the effect of public policies on economic growth is indirect and diffuse. The fact that public policies create demand in the economy means that they also indirectly create demand in the private sector. And when the demand in the private sector is high enough to warrant investment, firms will be willing to take risk and invest. They will employ more people, operate more productive machinery and expand markets.
All this means two things. First, that the government can intervene in the economy much more frequently than previously thought possible; and second, that the impact of government interventions can be quite dispersed over the whole economy, and not concentrated in any one economic sector. By increasing aggregate demand in the economy, public spending encourages the creation of more jobs, more businesses and more productive machinery. The more jobs created, the more productive the new infrastructure is likely to be. This means the economy will eventually have a higher standard of living than would otherwise have been the case.
However, the indirect effect of public policy can itself have an adverse impact on the economy. As the government steps in to fill the gap where private sector investment leaves off, the result can be “crowding out” by the public sector. When the infrastructure costs rise because there are no private firms willing to take the risk of making a relatively modest investment in improving roads and other public infrastructure, the rising cost is passed onto the consumer, who then reacts by reducing his own demand for goods and services. So, while public expenditure may have some positive effect on economic growth, it is important to remember that this is a . . . . . . two-way street, with public spending also having a negative effect on the economy.