Transcript Remedy for Economic Crisis: Spending or Austerity

Tar or Honey?
Cure for Recession Debate
Linas Čekanavičius
Vilnius University
Longstanding debate
...whether government
SPENDING or AUSTERITY
should be employed
in order to overcome financial downslide
and to set economy straight?
Two opposite schools:
 Spending (Honey):
fiscal stimulus via increased government
borrowing and spending and/or tax cuts
Austerity (Tar):
budget deficit reduction via public spending
cuts and/or tax hikes
How does Spending work?
When the Crisis hits...
Y = C + I + G + NX
How does Spending Work?
Y = C + I + G + NX
P
AD*
AD
AS
Y2
Y1
Y (Q)
Government
Purchases
Multiplier
Govt Purchases Multiplier
Works best when:
Money are spent on domestic goods
Short-run prices are fixed
Total Fiscal Rescue Package as a Percentage of GDP in 2009
14
Economic growth
Spending increases vs. tax cuts
Shortcomings
of Spending
Time lags
Spot the bastard-> Take action -> See effect
Debt
Consuming today at the expense of tomorrow
Austerity?..
Situation in which there
is not much money and
it is spent only on things
that are necessary
(Merriam-Webster Dictionary)
Source: TheTelegraph
Definition
Actions taken by the government, during a period of
adverse economic conditions, to reduce its budget deficit
using a combination of spending cuts and/or tax rises
(Financial Times Lexicon)
Budget deficit
Countries exceeding 90% of their debt-to-GDP ratio demonstrate
significantly slower economic growth rates
Public debt
Revenues
Expenditure
Budget deficit
Revenues
Expenditures
Tax hikes
Spending
cuts
How does it work?
Spending cuts
Tax increases
• …make businesses anticipate
tax cuts in the future
• …lower interest rates
Encourage investment
Output growth
Austerity measures
The Good – Spending Cuts
• Features
• the most growth-fostering austerity policy
• politicians less able to misallocate resources
• Empirical evidence
• economy-expanding fiscal adjustments are better served by
spending cuts, rather than tax increases
• Case study:
• Iceland, having cut spending by more than
4% of GDP, reached pre-crisis levels in 2012
The Ugly – Tax Increases
•Features
• expansionary effect depends on the current standpoint on
Laffer’s curve
•Empirical evidence
• “fiscal consolidation through spending cuts is less contractionary
than [...] through tax increases”
•Case study:
• France undertook several tax burden increases
between 2007 and 2012
• Its economic recovery was rather sluggish
The Bad – Mix of Two
• Features
• “spreads the pain across [both] the public and private sectors”
• Empirical evidence: not so bad?
• combination of both options leads to economic growth if followed
by appropriate growth-enhancing reforms
• Case study:
• Estonia engaged in both sharp public spending
contraction and substantial tax increases
• Its economy exceeded pre-crisis level in 2014
Fallacy of composition
If everybody saves, who spends?
What is wrong
with Austerity?
Technical remark
Consumers cannot project future cash flows
Increased inequality
Smallest income earners lose the most
Conclusions
Mechanism
• S: Govt purchases multiplier boosts
• A: Expectations drive behaviour
Conditions
• S: Money spent on domestic goods; constant prices
• A: Rational decision-makers
Limitations
• S: Time lags & debt
• A: Income inequality; not working if implemented
simultaneously among trade partners
What is recovery goal:
 Status
quo ante downslide?
Might be not the best policy choice, as the euphoria of
the “boom and boost” period could have easily resulted
in the wrong investment decisions and therefore in the
misallocation of resources
Status quo ante boom?
Thank you
for your attention!