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PK's column today likens austerity policies to medieval bleeding-the-patient medical treatments - which seems an apt analogy. The column concludes with a point that Krugman has been building to for sometime - namely, "the startling conclusion" that cutting spending during an economic downturn can actually increase deficits and debt:

[W]hen you combine the growing evidence that fiscal austerity is reducing our future prospects with the very low interest rates on U.S. government debt, it’s hard to avoid a startling conclusion: budget austerity may well be counterproductive even from a purely fiscal point of view, because lower future growth means lower tax receipts.
In other words, there's a paradox - what I'm referring to as the paradox of austerity - whereby cutting spending actually worsens the long-run fiscal position. This is an argument that Richard Koo has embraced for some time, pointing out that when Japan reduced government spending in 1997, Japan's deficit exploded:
[T]he rush for fiscal consolidation now seen in Washington is an exact replay of what happened in Tokyo in 1997. The result for Japan was a horrendous double dip where its GDP contracted for five quarters and its banking system went down with it. As a result, the deficit, instead of contracting, increased by a whopping 68%!
One gets the impression the math has been giving Krugman these results for some time, but he was a bit taken aback by the paradoxical results. The first time I remember hearing the paradox of austerity was in July of 2010. At that point, Krugman actually said he'd been hesitant to publicly say what the math was telling him:
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.

A year later, Brad Delong spelled out the argument as follows:
The Keynesian logic for expansion right now is reinforced by the fact that recessions and austerity programs cast shadows: raise unemployment now via austerity cuts in government spending, and some of that increased unemployment sticks around permanently as higher structural unemployment. Call the share of unemployment that does so s. Then an austerity program today worsens the long-run debt-and-deficit picture if:

mt > (r - g)/(r - g + s)

where m is the multiplier, t is the marginal tax rate, s is the share of the cyclical recession rise in unemployment that turns into a permanent rise in unemployment, r is the real interest rate on government debt, and g is the economy's real growth rate. Since right now mt is about 0.5, and r is less than 2% per year, this means that fiscal contraction is bad for the long-run debt-and-deficit right now as long as:

s + g > 2%

As long as the sum of the economy's long-term growth rate--which is now about 3%--and the share of a rise in unemployment that becomes structural is greater than 2%--which it definitely is--fiscal contraction is a bad, imprudent, and spendthrift thing.

And, in response to Brad's post, Krugman agreed and spelled out the argument sans geeky equations:
[T]here’s a very good case to be made that we’re currently living under conditions in which fiscal contraction actually worsens the long-run deficit. Why? The argument runs like this:

1. Fiscal contraction reduces output in the short run; this immediately means that part of the initial gain in terms of a lower deficit is offset by reduced revenue and higher safety-net spending. These effects are especially large when you’re in a liquidity trap, so monetary policy can’t fight the fiscal contraction.

2. Reductions in short-run output and employment take a toll on long-run growth, too: capital investment is depressed, workers lose their skills, and so on. This in turn reduces future revenues.

3. Meanwhile, with real interest rates very low — actually negative on 5-year bonds — the cost of borrowing now in terms of future debt burden is also very low.

So there is no plausible argument on behalf of the claim that fiscal contraction expands output; there is, on the other hand, a very plausible argument to the effect that fiscal contraction doesn’t even help the fiscal situation.

Although this is a critical economic point, I can understand Krugman's hesitancy - it is a difficult point to get across. It's paradoxical that cutting spending can actually increase debt.

And think about what this means for the politics. Austerity, a pro-bankster policy, also has a visceral and common sense appeal (in a US-budget-is-like-a-household-budget kind of way). And that's a bad combination: When the seemingly obvious solution aligns with the interests of rentiers, it's just not likely that a subtle, largely technical point will win the day.

Cross-posted at Plutocracy Files.


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Originally posted to PlutocracyFiles on Mon Sep 19, 2011 at 04:33 PM PDT.

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