Seeking Alpha
Macro, tech, independent research
Profile| Send Message|
( followers)  

The Economist asks: "Are current deficit reduction plans likely to boost growth?"

And Roberto Perotti answers:

The honest answer is that we don't know: The honest answer to the question of whether fiscal retrenchments will boost growth is that we have no idea. In monetary policy, we all agree that a hike in the federal funds rate will slow down inflation and growth; there might be some disagreement on when and by how much, but even that is limited. No such thing when it comes to fiscal policy: here, even the sign of the effects of a fiscal retrenchement is the object of bitter disagreement. Perfectly competent and reasonable individuals hold the view that when government spending increases individuals feel poorer because taxes will have to increase to pay for the extra spending; hence private consumption will fall...

HUH?!

Increase government spending this year by one dollar. You also increase the present value of future taxes by one dollar: private-sector agents thus feel poorer by one dollar. They are likely to cut back on their consumption by some amount. Perhaps they are looking forward to an expected lifespan of twenty-five years and are not terribly worried about the additional tax burden on their heirs, in which case they will spread the reduction in consumption over their entire future consumption path and cut back consumption spending this year by... four cents.

Four cents is not equal to one dollar.

$1.00 - $0.04 = $0.96

Perotti worries that "when government spending increases individuals feel poorer because taxes will have to increase to pay for the extra spending; hence private consumption will fall..." But this is not just not a first-order consideration, it is not a second-order consideration. We can debate whether it is a third-order or a fourth-order consideration.

But somebody who thinks that an extra dollar of government spending this year is neutralized by a one-dollar cutback in this year's consumption spending through the after-tax wealth and permanent income channels seems to me to be neither reasonable nor competent.

Source: Fiscal Policy: Department of 'Huh?!'