Sunday, March 10, 2013

Self-defeating austerity

By Frankly Curious

The International Monetary Fund (IMF) has just put out a paper on austerity. It argues that in the medium term, austerity is self-defeating. This is because austerity causes the economy to shrink by a greater percentage than the debt shrinks.

When deficit scolds talk about the national debt, they almost always do it in raw numbers. This is because "$14 trillion" sounds a lot more scary than "Our debt is equal to about our yearly productivity." But the proper way to look at government debt is relative to GDP or even more so Potential GDP. Traditionally, the way to get debt paid off is to outgrow it. This is how we got rid of most of our debt from World War II. (At least we did until that great debt cutter Ronald Reagan got into office.)

Given this fact, when looking at debt, we have to look at two variables: the size of the debt and the size of the economy. Those who would have us cut and tax our way out of debt introduce the concept of "confidence." This is the idea that businesses will see that the government is "serious" about debt, think the economy will soon by roaring, and so start investing in capital equipment and hiring people. This is a ridiculous idea that shows a shocking level of ignorance about how businesses actually work. As we have seen again and again, when the government cuts its spending, businesses correctly determine that the bad economic times will continue. This is exactly why business groups were against the Sequester.

There is, of course, a time when cutting government spending will help the economy: during a boom. When the economy is humming along, government debt can make it more expensive for businesses to borrow money. This is because the government has to borrow a fair amount of the available funds to service its debt. But that is most definitely not the case right now. In a depressed economy, there is too much money looking for too few opportunities to be used. Now is exactly the time for the government to be running large deficits.

Paul Krugman created a simple model of the effect of austerity on the government's debt to GDP ratio. He calls the country Osbornia, after the austerity true believing Prime Minister of the UK. He assumes an economy very much like our own and shows that after 5 years of gradual austerity, the debt problem is worse than doing nothing for 6 years. Of course, the problem isn't one round of austerity. The problem is that austerity is piled on top of itself. We've seen this in the 2011 deficit deal, then the Fiscal Cliff deal, and now the Sequester deal.

All of this shows what we already know: all of this austerity (which isn't nearly so bad as what they are dealing with in Europe) is slowing our economic recovery. What we need is to put people to work and grow the economy. Even the conservatives claim to understand this. The problem is that they seem to think that the way to grow the economy is to destroy the government and allow the "magic" of the market to work. The problem is that everything we know about economics shows that this isn't the case.

(Cross-posted by Frankly Curious.)

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