What Nobody Tells You About Austerity and Budget Deficits

Finally the secret is out: the International Monetary Fund (IMF) made a major mistake in its calculations and discovered - surprise, surprise - that austerity measures hurt an economy in recession! The news have reverberated in the press in Europe - I'm still waiting for the New York Times to catch up (unless it's hidden in some back page, please let me know - but it certainly hasn't been a featured article). 

Why is the New York Times mum about this? Probably because it's hard to budge deep-seated convictions that budget rectitude is good - indeed, the word "rectitude" tells it all. Journalists and politicians keep mistaking balancing the government budget with balancing the family budget. What's good and right for a family isn't good and right for a country. I've posted about this many times before and won't go into it now. Suffice to say that balancing a state budget is something you should do over a business cycle (i.e. several years) and not over a single year or two. And you should use the government's budget as a countervailing weight: when the economy is in recession, the state should lighten taxes and spend money to keep the economy going since recession is a result of businesses withdrawing from the market place. When boom times return is when the state should withdraw its presence from the market and seek to balance its budget. Not before, not during the recession.

No doubt the US is about to find out the hard way as "sequestration" hits the economy...

But let me get back to what the IMF just revealed: its Chief Economist, Olivier Blanchard just confessed that since the beginning of the crisis they had mistakenly calculated the fiscal multiplier at a level that was too low and hence vastly underestimated the impact of austerity on European economies. The IMF had assumed a multiplier of 0.5 when in fact all countries except Germany had a much higher multiplier, as you can see here:

Germany:  0,08
France: 0,82
UK: 0,87
Italy: 2,10
Spain: 2,60

This looks like a technicality but it isn't. It means that taxes and/or a cut in government expenditures will have a ginormous effect on economies like Italy's or Spain's as compared to Germany that will hardly feel anything (0,08 is peanuts!).

Like this compared to France and the UK:

And like this compared to Italy and Spain (illustrations from Panorama where the article was published on 27 February 2013): 

Yes, Spain is grounded! Germany can withstand fiscal rectitude with its booming export economy but Spain, Italy, Greece, Portugal cannot. Raising taxes is a sure recipe to send an economy in the doldrums - as the latest data on unemployment in Europe amply prove.

The only exception?  Ireland which is usually pointed to as the "good pupil" in the class, the proof that austerity works. Unfortunately, in the case of Ireland, there is something else at work: it is actually saved by having turned itself into a sort of fiscal paradise within the European Union. Unlike other EU members, it doesn't charge corporations the high tax you find elsewhere in the Union. Result? All the big American corporations are headquartered there and operate in Europe from Ireland. Neat, isn't it?

For those of you who are economists and interested in the latest research on fiscal policy and the fiscal multiplier, there is an interesting paper published by the Brookings Institution last year, click here. The authors are both prestigious NBER economists: Harvard's Lawrence Summers and Berkeley's Bradford DeLong The paper examines the efficacy of fiscal policy in severely depressed economies under the special circumstances when interest rates are constrained (as they are now) by the zero nominal lower bound. A must read for economists and an eye-opener for those brave enough to plod through!

More about it in Paul Krugman's excellent article, see below:
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