Fiscal Austerity & GDP Growth

http://www.economist.com/node/17147618?story_id=17147618&fsrc=rss

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"The value of life lies not in the length of days, but in the use we make of them; a man may live long yet live very little." (Michel Eyquem de Montaigne - French Essayist)

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Again a solute to one of my former students who sends a most interesting article on settling the arguement amongst macroeconomists and politicians on the issue of reducing government spending as a path to long term growth.

Terms like "Cyclically Adjusted Primary Fiscal Balance" (CAPB) are, for us, real sleep inducers but the studies that determine whether it is appropriate to claim GDP growth can result from government cost reductions are important. The "Economist" article attached outlines the debate on that issue and concludes that cutting back does not do what some in government think it does.

We're guessing there is "debate" on this issue because economists can't agree on what time it is, let alone the effects of fiscal austerity. We're also guessing that one of the lessons of the Great Depression is being ignored in this modern debate: the U.S. government decided to be fiscally "austere" in 1937 and simply made things worse. What is that old saying about those who ignore the lessons of history ...?

Fortunately, Ben Bernanke (whose PhD work was done on the Great Depression) has not ignored that lesson and will be continuing to "spend" (if the current Fed discussions are acted upon). But, of course, there is much debate about QE (Quantitaive Easing: just a fancy two word classification for the Fed spending money) and how much of an effect it can have on the economy.

In any case, the IMF study on belt tightening carefully defined "intent" and "action" in defining what quantitative results to study and compare.

The IMF concluded that, on average, a rich country attempted a fiscal contraction of more than 1.5% of GDP about once a decade. It concluded that the typical such episode is clearly contractionary: a fiscal consolidation of 1% of GDP leads on average to a 0.5% decline in GDP after two years, and an increase of 0.3 percentage points in the unemployment rate. The charts supporting this conclusion showing trend lines for net exports, unemployment, GDP and domestic demand are excellent.

Interestingly, simulations carried out by the fund show that slashing spending in an environment where interest rates have no more room to fall DOUBLES the contractionary effect of such cuts compared with a situation where the central bank still has scope to cut rates.

In English, it is stupid to go for fiscal austerity programs in the middle of a severe recessionary environment. We believe it was Paul Krugman (along with Warren Buffet) who said the U.S. economic stimulus package was not large enough, and went on to say that spending "big" now will save the economy now, and that fiscal austerity can be achieved when we get back to full employment.

Then, of course, there is the history that we are doomed to repeat.