Is there an austerity curve?

I’m intrigued by Duncan’s idea of an austerity curve. - the idea that:

cutting government spending up to a certain point leads to lower deficits but beyond a certain point, the impact of lower growth and higher unemployment means that deficits get worse as the government cuts more.

If you support the Labour party’s position of supporting small cuts but not large ones, you have to believe something like this*.

It seems to me that this is only possible if the multiplier varies with the size of cuts. For small cuts, the (negative) multiplier must be sufficiently small that GDP doesn’t fall so much that tax revenues fall and benefit spending rises by more than the initial cuts. But for larger cuts, the multiplier gets bigger, and so big austerity backfires.

To fix ideas, let’s say that a one percentage point drop in GDP leads to the deficit rising by 0.7 percentage points (pdf) of GDP. It follows that for an austerity curve to have the shape Duncan suggests, the multiplier must be less than 1.4 (1/0.7) for small cuts, but more for large ones.

I can imagine three possible reasons for this:

1. The monetary policy response. Bigger fiscal austerity requires a bigger loosening of monetary policy. But this might not work. The efficacy of quantitative easing is uncertain - partly because it works by reducing tail risk, and this varies over time. A big fiscal tightening thus increases the possibility that the monetary policy response will be inadequate, whereas a smaller fiscal tightening runs a smaller risk.

2. Labour market adjustment. With decent active labour market policies, it’s possible that a few thousand redundant public sector workers can be retrained or repositioned for private sector work. But it’s less possible to do this for hundreds of thousands of them. Greater austerity might therefore increase the mismatch between the unemployed and vacancies, thus worsening the Beveridge curve.

3. Signalling. Big austerity signals that there is a serious risk of a debt crisis. But business might take fright at this signal, and thus cut investment. More modest fiscal adjustment - a “touch on the tiller” - needn’t have such adverse signals. (I’m thinking here of a loose analogue to Caplin and Leahy’s famous paper (pdf) on monetary policy signals).

The idea of an austerity curve is, therefore, not obviously wrong - though I challenge anyone to quantify all this.

But nor is it obviously right. One could argue to the contrary, that small fiscal tightening might have bigger multiplier effects. This would happen if people think that more cuts will be needed in future, and so business investment falls as firms anticipate long years of austerity.

My point here is, I fear, merely a somewhat nihilistic and cliched one. It’s that the response of economies to macro policies varies over time and place, so that there are few stable coefficients. It is therefore simply not possible to know the precisely correct macro policies. Which makes the debate between big cutters and little cutters a little like arguments about how many angels dance on the head of a pin.

* I don’t think the alternative justification for such a position - that the economy can take small cuts but not large ones - is terribly persuasive, as it’s not obvious that it can take even small cuts.

Comments

[Luis Enrique]

"Which makes the debate between big cutters and little cutters a little like arguments about how many angels dance on the head of a pin."

except, presumably, that the decision whether to make big or little cuts will have important real-world consequences, even if we lack the theoretical and empirical understanding to predict what it will be.

even if you think the IMF has changed it's tune too recently, its current advice to take fiscal adjustment slowly would seem to be consistent with the idea of non-linearity.

[Bruce]

Try extending the curve from 'Extreme Austerity' to Zero Government Spending.

It would start curving back toward lower deficit, and eventually zero deficit, would it not?

[UnlearningEcon]

Bruce I'm not sure of your point. There wouldn't be an economy.

[Ralph Musgrave]

Duncan Weldon’s idea is pure unmitigated B.S. It is simply a minor variation on the conventional and nonsensical wisdom, namely that consolidation causes austerity. For an explanation as to why consolidation DOES NOT cause austerity, see:

http://mpra.ub.uni-muenchen.de/34295/1/MPRA_paper_34295.pdf

As for the importance that Weldon attaches to the views of the IMF, Prof. Bill Mitchell regards the IMF is disastrously incompetent and not fit for purpose, a view I share. Mitchell has written a large number of blog posts on the IMF’s incompetence: just Google “Billyblog” and “IMF”. See also:

http://ralphanomics.blogspot.com/2012/01/mind-boggling-stupidity-from-imf-and.html

[D]

The reason why cuts hurt is that that government spending increases GDP and thus revenue, and in theory, government spends money on things which increase GDP more than they cost - for example, redistribution to people excluded from employment not only reduces the costs of social unrest and of service provision arising from poverty and boosts demand by moving money from people with lower marginal propensity to spend and gives it to people with higher marginal propensity to spend. Or spending on social services and early intervention which is cheaper than spending on the other services which people end up needing without social services.

[Atim]

pebird, The Greens in the UK used to be olrvtey in favor of a zero economic growth model as in your 8a. There must be no increase in net financial assets over a business cycle, regardless of the productivity of the economy. Its perfectly possible to have increasing affluence due to increasing efficiencies whilst at the same time having asset price deflation due to a government surplus surely?

[Muhammad]

The Thirteenth Angel Gala is a wfrednoul helpful event that gives back to the surrounding communities in need in Toronto. Everyone who participates becomes an activist to help other people. Very rewarding.