All entries for Tuesday 29 May 2012

May 29, 2012

Dont believe the 'austerians': a fiscal stimulus is just what is needed

We know the coalition government's austerity policy is not working. The economy is not growing with output still 4% below its level before the crisis began in 2008. Output is estimated at a staggering 14% less than where it would have been had growth continued at the rate it was before the recession.

But we are told there is no plan B - that Keynesian fiscal stimulus is not available because it would have to be financed by more borrowing. This is economic nonsense that is doing immense damage to society.

All the evidence shows that cutting public spending in a recession simply makes things worse. And it does little - if anything at all - to reduce the deficit because other areas of government spending go up and tax revenues drop.

The deficit is a by-product of recession, not a cause. The only way to reduce the deficit is to promote economic growth which put unemployed people back to work. In the absence of any growth stimulus from the private sector, this means using government spending to provide the fiscal boost.

In my latest paper, published in the latest Royal Economic Society Newsletter, I have shown that a fiscal stimulus, aimed at pump priming the economy by getting the private sector growing again, is actually also good for fiscal solvency. The growth in output as a result of the operation of the Keynesian multiplier also means the debt to GDP ratio will come down. This happens even if the extra spending is funded by borrowing.

This result is true even under quite mild assumptions about the size of the fiscal multiplier. I assumed a multiplier of 1: that is, that an increase in government spending would induce an increase in GDP of the same amount. This is a very small effect. There is growing evidence that the effect will be much larger than this.

A similar case has recently been made in an important paper by Brad DeLong and Larry Summers.

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