Austerity is the new black

Watching Fareed Zakaria this morning and he had an interesting panel Eliot Spitzer, Chrystia Freedland, Ann Coulter, and Andrew Roberts.

They were talking about the Republican presidential field as well as a discussion of Keynes vs Hayek. What I found interesting is, that when you have austerity advocates, they never explain the mechanism by which austerity works. Do not get me wrong there is a time and place for cuts in spending and to be more thrifty in general, however, when you are in the midst of the worst recession since the Great Depression and pushing up against the zero lower bound. You need to explain how removing money from the economy will encourage growth. I have not heard that explanation given. Generally it is cloaked in talk of "confidence", and not the standard language of supply and demand. So I am highly suspect of it as an explanation.

That being said, Paul Krugman does a spectacular job of illustrating what the problem is with the austerity movement during a recession:

Self-defeating Austerity

There’s a quite good case to be made that austerity in the face of a depressed economy is, literally, a false economy — that it actually makes long-run budget problems worse.

People like me have been hesitant to make this argument loudly, for fear of being cast as the left equivalent of Arthur Laffer — but the heck with it, I’m going to lay it out.

So here’s the outline. Suppose you slash spending equal to 1 percent of GDP. That looks like a budget saving, right? But if you do it in the face of an economy up against the zero bound, so that the Fed can’t offset the demand effects with lower rates, it’s going to shrink the economy. Let me use a multiplier of 1.4; you can adjust the numbers as you wish.

Now, a weaker economy means less revenue. Assume that every dollar up or down in GDP means $0.25 in revenue, which is conservative. Then the fiscal austerity reduces revenue by 0.35 percent of GDP; the true saving is only 0.65 percent.

Now, the government has to borrow those funds; let’s say the real interest rate is 3 percent (it’s actually much lower now). Then the long run impact of the austerity on the fiscal position is to reduce real interest payments by 0.0195 percent of GDP.

But wait: what if there are long-run negative effects of a deeper slump on the economy? The WSJ piece showed one example: workers driven permanently out of the labor force. There’s also the negative effect of a depressed economy on business investment. There’s the waste of talent because young people have their lifetime careers derailed. And so on. And here’s the thing: if the economy is weaker in the long run, this means less revenue, which offsets any savings from the initial austerity.

How big do these negative effects have to be to turn austerity into a net negative for the budget? Not very big. In my example, the real interest payments saved by a 1 percent of GDP austerity move are less than .02 percent of GDP; if the marginal tax effect of GDP is 0.25, that means that a reduction of future GDP by .08 percent is enough to swamp the alleged fiscal benefits. It’s not at all hard to imagine that happening.

In short, there’s a very good case to be made that austerity now isn’t just a bad idea because of its impact on the economy and the unemployed; it may well fail even at the task of helping the budget balance.

It’s important to realize that I’m not saying that government spending always pays for itself, and that saving money is always counterproductive. These kinds of effects are specific to a liquidity trap situation. But that’s the situation we’re in.

I have not seen a counter to this other then, "Austerity will increase confidence!". We have a demand problem. Until that is addressed confidence is the least of our worries.

-Cheers