Expansionary fiscal consolidation

Earlier this week I had an opinion piece in The Canberra Times (a link is available here) quashing the notion that reductions in unproductive government expenditure will render significant harm to an economy.

The idea that spending cuts should be avoided from an economic standpoint is closely attuned with the Keynesian macroeconomic notion that reductions in expenditure by government will lead to a reduction in aggregate demand thus contributing to a fall in output and an adverse divergence away from a full?employment equilibrium state. 

Of course, my Catallaxy colleague Steve Kates has already taught us many valuable lessons when it comes to the intellectual poverty of Keynesian ideas. 

Without intending to steal Steve’s thunder of a classical economic repudiation of Keynesianism, my piece instead covers developments in modern macroeconomic theory which address a few key flaws in the Keynesian edifice: (i) the inclusion of a market for the supply and demand for money and credit; (ii) the inclusion of an external sector of the economy incorporating financial flows across national borders; and (iii) the role of expectations of the private sector in response to changing public sector policies.

All of these theories, which are taught in intermediate to advanced macroeconomic courses in most universities today, illustrate that the correspondences between private and public sector activities are far more complicated than what Keynes and his followers were able, or prepared, to acknowledge.

The developments in macroeconomics that I cited in the piece, and others that I didn’t have space to mention (such as the response of foreign investors to changes in fiscal stance), give rise, to some extent, to the possibility of an expansionary (rather than contractionary) economic response to fiscal consolidation. 

The economists Alberto Alesina and Silvia Ardagna (see here) have cited a number of important case studies to support the theoretical contention that reductions in government expenditure as a way to restore sound fiscal order are more economically effective, at least in terms of recession avoidance, than fiscal consolidations based on tax increases. 

One of the cases of fiscal consolidation studied by Alesina and Ardagna was the deficit reduction efforts of former Prime Minister Hawke and Treasurer Keating in the mid?1980s, that eventually led to the budget that brought ‘home the bacon’ as Keating exuberantly claimed. 

As I explained in the opinion piece, they could well have included the Howard?Costello fiscal consolidation efforts in the late 1990s as part of their field evidence. The fiscal consolidation of former Prime Minister Howard and Treasurer Costello was largely (but granted not exclusively) focussed on expenditure cuts, including the application of a ‘yellow pages’ test for market outsourcing of administrative functions, a right?sizing of the Australian Public Service and reductions to a number of ineffectual labour market and industry policy programs. 

The transition away from a commonwealth budget deficit contributed to some of the beneficial effects that assisted Australia during the 1998 Asian financial crisis, including an exchange rate depreciation and interest rate reductions. Apart from expected effects upon the public service citadel of Canberra, economic growth outcomes nationally weren’t adversely affected by the spending cuts, either.

Given the accumulation of theoretical explanations that contradict the Keynesian government spending cut gloomsaying, and the plentiful examples both at home and abroad of fiscal consolidations that freed up space for the efficient private sector to grow, it is a wonder why the government and its economic advisors were fervently in support of unnecessary fiscal stimulus in 2008?09 and so reticent to reduce expenditure even further today.

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29 Responses to Expansionary fiscal consolidation

  1. Pingback: Expansionary fiscal consolidation | My Blog

  2. Skuter

    it is a wonder why the government and its economic advisors were fervently in support of unnecessary fiscal stimulus in 2008?09 and so reticent to reduce expenditure even further today

     
    Perhaps they own properties in Canberra and they are looking out for the value of their assets…

  3. RodClarke

    Agreed. Its funny how Kaynesians never argue for tax cuts as a way to stimulate the economy.

    Just think how quickly QLD flood damage (for example) would get fixed if you made it a tax free zone for a period of time.

  4. kennedy

    “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.”

  5. kennedy

    More specifically in Australia:

    economic growth outcomes nationally weren’t adversely affected by the spending cuts

    This was because public spending was replaced by private demand fuelled by increasing levels of private debt

    When a country has a current account deficit and a budget surplus there is no way to avoid a private domestic deficit.

    Now, no one believes that increasing level of private debt are sustainable into perpetuity so the only way to maintain aggregate demand in Australia (when private debt is high) is to have a lower currency (and associated boost from Net Exports) or to have government deficit spending.

  6. kennedy

    The economists Alberto Alesina and Silvia Ardagna (see here) have cited a number of important case studies to support the theoretical contention that reductions in government expenditure as a way to restore sound fiscal order are more economically effective, at least in terms of recession avoidance, than fiscal consolidations based on tax increases. 

    Spending cuts will always have a larger initial drain on aggregate demand than tax increases.

    A cut in government spending (say of $1000) is an exogenous withdrawal from the aggregate spending stream and this directly reduces aggregate demand by that amount while tax-increase does not directly impact on the spending stream in the same way as the cut in government spending.

  7. kennedy

    Given the accumulation of theoretical explanations that contradict the Keynesian government spending cut gloomsaying

    How is the UK going with its government spending cuts?

  8. kennedy

    “It’s really amazing to see how quickly the notion that contractionary fiscal policy is actually expansionary is spreading…

    So what does this view rest on? Partly on vague ideas about credibility and confidence; but largely on the supposed lessons of experience, of countries that saw economic expansion after major austerity programs.

    Yet if you look at these cases, every one turns out to involve key elements that make it useless as a precedent for our current situation.

    Here’s a list of fiscal turnarounds, which are supposed to serve as role models. What can we say about them?

    Canada 1994-1998: Fiscal contraction took place as a strong recovery was already underway, as exports were booming, and as the Bank of Canada was cutting interest rates. As Stephen Gordon explains, all of this means that the experience offers few lessons for policy when the whole world is depressed and interest rates are already as low as they can go.

    Denmark 1982-86: Yes, private spending rose — mainly thanks to a 10-percentage-point drop in long-term interest rates, hard to manage when rates in major economies are currently 2-3 percent.

    Finland 1992-2000: Yes, you can have sharp fiscal contraction with an expanding economy if you also see a swing toward current account surplus of more than 12 percent of GDP. So if everyone in the world can move into massive trade surplus, we’ll all be fine.

    Ireland, 1987-89: Been there, done that. Let’s all devalue! Also, an interest rate story something like Denmark’s.

    Sweden, 1992-2000: Again, a large swing toward trade surplus.

    So every one of these stories says that you can have fiscal contraction without depressing the economy IF the depressing effects are offset by huge moves into trade surplus and/or sharp declines in interest rates. Since the world as a whole can’t move into surplus, and since major economies already have very low interest rates, none of this is relevant to our current situation.”

  9. kennedy

    The idea that spending cuts should be avoided from an economic standpoint is closely attuned with the Keynesian macroeconomic notion that reductions in expenditure by government will lead to a reduction in aggregate demand thus contributing to a fall in output and an dverse divergence away from a full?employment equilibrium state.

    In the US it was the US Housing Bubble and Financial Crisis that contributed to the “adverse divergence away from a full?employment equilibrium state”.

    Government spending is required to help support aggregate demand because of depressed private sector demand and the drain from net exports.

    So yes, spending cut should be avoided but not to avoid the divergence from full employment (which happened because of the Housing Bubble) but to support the return to full employment.

  10. Skuter

    Kennedy,

    See the following post

    Substitute ‘Kennedy and other MMTers’ for ‘Summers’ – Then get back to me

  11. JC

    Kennedy

    stop posting spam posing as economics.

    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.

    Kennedy , this is horseshit. The CB is not limited to zero bound you ignoramus.

    Stop posting crap up here as no one believes your drivel masquerading as economics.

  12. Jim Rose

    Both Australia and New Zealand pursued strongly contractionary fiscal policies in the 1930s.

    Unemployment rates in both countries were in the mid-single digits by 1935.

  13. JC

    Jim

    Not even a jackhammer applied to the head for 24 hours straight will change Kennedy’s mind that the Lurch/Rudd insulation fiasco was the best policy response to a mild recession in a generation.

    In Kennedy’s mind we should have continued it in perpetuity because putting in the insulation then letting the houses burn down was a perpetual stimulus that raised living standards.

    Install.. let it burn… then build. on and on forever. It was perhaps the greatest wealth generation machine we’ve ever seen, according to Kennedy…. What a jackass.

  14. John Comnenus

    Kennedy (is it the member for Kennedy?) imagine the economy consists of 100 units of which 40 are the Government. Taxes on the Government recycles money already taxed from the private sector. Assume the government gets 25% of every dollar it spends back in taxes.

    To fund the 40 unit Government the private sector of 60 units has to be taxed 40 units minus the 10 units recycled in taxes raised from the public sector. To be in balance you need a tax rate of 50%: 40(Government spending) – 10 (taxes raised on government sector) = 30 which is half of 60 (private sector).

    If you grow the public sector you have to take from the private sector. But that reduces the tax base – or the part of the economy that actually generate new taxable income.

    If in our model the public sector was reduced from 40 to 30 (a 25% cut) and tax rates stayed the same at 50% then you would actually get more money because 50% of 70 is 35 and 25% of 30 is 7.5. Add them together and you end up raising 42.5 rather than 40.

    If you do the opposite and grow the government from 40 to 50 then you get taxes raised from government of 12.5 deducted from 50 = 37.5. The tax bill for the private sector is now 37.5 of the private sector’s 50 units. You are now approaching an 80% tax rate to fund the public sector. This is why increasing spending demands disproportionately large increases in taxation.

    Cutting tax rates grows the taxable income of the whole economy. Which in turn generates more tax income for the government but at lower percentage rates. Increasing government concurrently destroys the tax base whilst demanding more from it.

    If you accept Kennedy’s Keynesian model then every dollar of borrowed stimulus has to be paid back with interest. Kennedy’s multiplier works on every borrowed stimulus dollar. This means more money leaves the economy over the life of the loan than ever went into the eocnomy in the first place. Go to a mortgage calculator and work out how many extra dollars you pay over the life of a loan and apply your 1.4 multiplier to work out how much borrowed stimulus shrinks the economy over time.

    I note reports that Japan pays 50% of all Government revenue to service its monstrous debt. That debt is predominantly borrowed from the Japanese people, rather than off shore. Eventually the Japanese government’s profligacy will liquidate the nations savings, just as that population goes into retirement. The idiocy of Keynesian borrowed stimulus knows no bounds.

  15. Biota

    John, as I understand it you have described a closed system and I think from other threads the Kennedy/Cris escape valve is printing more money. Should I stick to biology?

  16. kennedy

    Hi John

    I don’t think your example stacks up – here are two points:

    I note reports that Japan pays 50% of all Government revenue to service its monstrous debt

    Japanese interest rates are approx. 1% and net debt / gdp is approx. 120%. so the government interest burden is 1.25 of gdp (not 50% of revenue)

    If you grow the public sector you have to take from the private sector

    This is incorrect at the present time in the US. There are plenty of idle resrouces (9% unemployment) from which to “grow” the public sector without compromising the resources available to the private sector.

  17. kennedy

    Hi JC

    You will be happy to know that I think the pinkl bats program was a total fiasco, a farce and a waste of REAL RESOURCES.

    But I still believe that government stimulus was the correct response to the GFC.

    …and these two opinions are not inconsistent!

  18. Mother Hubbard's Dog

    Seems to me that there is room for some compromise in this debate. First, there is the issue of capacity utilization. In an economy with low capacity utilization, high unemployment and low business and consumer confidence, cutting government spending does not seem to be the most obvious response. Yet there seems to be some evidence that it works. Why? I think part of the solution lies in the first sentence of Julie’s intro above, referring to “unproductive government expenditure”. Clearly in any modern government there accrues over many years a myriad of large (and small) areas of expenditure which are at best wasteful and at worst counterproductive to society as a whole. Thus an occasional concerted effort to rid society of these unnecessary burdens, which can more easily be justified in times of hardship, will reap considerable dividends in terms of increased efficiency.

    Governments frequently pretend to be doing this, as alluded to in Julie’s CT article, but unless times are really tough they rarely “bite the bullet” on many of the really hard decisions. Even the Hawke/Keating government, which Julie alluded to as providing evidence of the value of fiscal prudence, was memorable for Peter Walsh’s description of Hawke as “old jellyback”.

  19. John Comnenus

    Clearly my 100 unit economy was a simplified model that showed the logic of cutting government spending and tax rates to gain more income. Yes there are international factors and flows at work, and yes we don’t have 100% resource utilization either. The example was illustrative.

  20. Rafe

    Kennedy, I think some of us will not let you use a multiplier of 1.4. What if you use a multiplier less than 1? Like 0.4?

  21. .

    Japanese interest rates are approx. 1% and net debt / gdp is approx. 120%. so the government interest burden is 1.25 of gdp (not 50% of revenue)

    Bullshit.

    This is incorrect at the present time in the US. There are plenty of idle resrouces (9% unemployment) from which to “grow” the public sector without compromising the resources available to the private sector.

    You idiot you are trying to peddle causation from your misunderstood equation you didn’t even know the make up of.

  22. kennedy

    Hi JC

    I do try to respond to your questions.

    Ken Arrow was the economist defending more controlled labor markets and the philly research suggesting that wage hikes raise employment

    Here is a link from a Card and Kruger study of minimum wages.

    The facts are more nuanced that you are willing to admit. The market for labour is more complicated than simple demand and supply.

    If we continue to reduce wages to encourage employment where will final consumption demand come from to purchase all the goods and services?

  23. Samuel J

    It is odd, Julie, that it is relatively uncontroversial that new Government spending which has a negative net present value necessarily detracts from national wellbeing.

    Yet when one proposes to cut existing government programs that have a negative NPV we are suddenly concerned about the withdrawal of the spending.

  24. Tom Valentine

    Kennedy,where does one start?Just 2 of many points.First,fiscal multipiers are very low under a floating exchange rate.Are you suggesting we fix it again?Second,you need to look more closely at the literature on wages and employment.It concludes that higher wages create unemployment.Card and Kruger have been discredited.

  25. .

    What happened to the Jackson and Robson stuff which totally blows that Car and Kruger crap out of the water?

  26. .

    http://www.brookesnews.com/050108actu.html

    http://www.cis.org.au/images/stories/policy-magazine/2004-summer/2004-20-4-alex-robson.pdf

    Honestly kennedy your “economics” is full on retarded. At least Quiggin has the intelligence and decency to say sometimes he’s making a social choice and not an economic one.

    You actually think the Government spending as much money as they can and strongly and frequently increasing minimum wages would see full employment and prosperity.

    You’re freakin’ nuts.

  27. .

    One last thing Kennedy. The MW doesn’t stop anyone from exploitation. If you get priced out of the market, you get your hours cut.

    Now – millions would earn more than the dole if they got a job that paid less than the MW – if the tax system was made good, they would have more after tax income than the dole.

    With that information and the parameters you set, clearly this is better than the status quo. You’d be increasing output and raising demand to boot.

  28. sdfc

    Julie

    That Alesina paper says little about effects of a fiscal stimulus or consolidation on a depressed economy.

    The authors themselves acknowedge this. Why drag this paper out over and over again?

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