Why austerity can make recessions worse

Spending money on roads might boost the economy. That's because the newly-paid construction workers will go out and spend their money too. Photo / Thinkstock

Cutting spending in a slump might actually make debt problems worse

There might be a worse idea than cutting spending during a depression, but I doubt it.

The fundamental economic question of the past five years has been a simple one: how much does stimulus work? The answer, according to a new paper by Daniel Riera-Crichton, Carlos Vegh, and Guillermo Vuletin, is much more than we previously thought. And that means austerity has also hurt more than we thought - so much so that it might even be self-defeating.

That's right: cutting spending in a slump might actually make debt problems worse.

It's all about the fiscal multiplier. Stimulus is measured by how much one dollar of government spending increases GDP. But in a normal economy, it doesn't.

That's because the Federal Reserve has its inflation target that it's determined to hit (or at least not overshoot).

Government spending, though, can flood the economy with money, raising prices in the process. So the Fed, in turn, would either raise rates to offset this spending it doesn't want, or wouldn't cut rates like it otherwise would have.

Either way, the Fed's actions would keep the economy from being any bigger with more government spending than it would be without it.

But this calculus changes when there's a recession, especially if interest rates are at zero. In that case, the Fed wouldn't want to neutralise stimulus spending. So GDP would grow at least as much as spending does - what economists call a multiplier of one - and maybe more since there could be spillover effects.

Think about it like this: spending money on roads and bridges might boost the economy more than just the money the government directly spends. That's because the newly-paid construction workers will go out and spend their money too - and so on, and so forth. Even the oh-so-orthodox International Monetary Fund estimates that the fiscal multiplier might be as high as 1.7 right now.

Riera-Crichton, Vegh, and Vuletin took this analysis a step further. They focused squarely on countries that, between 1986 and 2008, had both been in a recession and increased spending. This last point is critical. Stimulus, remember, is supposed to be countercyclical: the government spends more when the economy shrinks.

But historically-speaking, countries have actually cut spending about half the time that they've been in a slump. So counting all that austerity as "stimulus," as most do, gives us a misleadingly low estimate of the multiplier, something like 1.3. But it turns out, based on this new better sample, that the multiplier is really around 2.3 during a garden-variety recession, and 3.1 during a severe one.

That's not quite a free lunch, but, economically-speaking, it's a free mid-morning snack.

This leaves us in an upside-down world where smaller deficits might actually make our debt problems worse. When interest rates are zero, spending cuts can cripple the economy so much that GDP falls more than the government saves.

And that means the debt-to-GDP ratio might increase even though government spending is decreasing - like it has in Greece. That's why the IMF thinks infrastructure spending would almost pay for itself right now, and why economists Larry Summers and Brad DeLong have been saying the same for years now.

We can't afford austerity right now.

- Washington Post