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by Karl Smith

I tend to think the Austerity debate is so hopelessly mixed up with left-right politics that it is highly unlikely that even the blogosphere will come to clarity, let alone the wider policy community. Nonetheless, I'll try to make a few points.

Generally speaking, "austerity" is an attempt to reduce structural budget deficits. To do this, a government will attempt to increase the growth rate of structural revenues and decrease the growth rate of structural outlays. Outlays here include not just what we would think of as government consumption and investment but transfer payments, such as Social Security in the United States.

Both of these effects, an increase in the growth rate of revenue and a decrease in the growth rate of outlays will tend to be contractionary. Indeed, this is the entire point.

Let me emphasize this again because there is much confusion here-- the point of austerity is to be contractionary. If austerity is not contractionary, it cannot work.

Why? The idea behind austerity is to allow private sector investment to grow. But, for the private sector investment to grow it must have "room." Who determines how much room the economy has to grow? The central bank does.

So, austerity works by contracting the overall economy through increasing the growth of revenues and decreasing the growth of outlays. This allows the Central Bank to decrease the path of interest rates. A reduction in the path of interest rates increases total investment.

In this way, the economy has shifted away from consumption and towards investment. This shift is what makes austerity austere. You do with less now to have more later.

Once we see this we can see why austerity would be highly controversial from a macroeconomic standpoint right now. Here in the United States there is a major debate over the Fed's reaction function. My interpretation of their actions is that the reaction function is asymmetrical. That is, the Fed will move to speed up the economy if it slows down, but will not move to slow down the economy if it speeds up.

Ben Bernanke insists that the reaction function is symmetrical but also admits that the Fed will push the economy towards the long run equilibrium that it wants, rather than slamming on the gas or the breaks. It is clear that the Fed is not slamming on the gas now, and Bernanke argues that if inflation were running at over 3% the Fed would also not be slamming on the breaks. Instead they seek a smooth glide towards their long term goals.

This implies that fiscal policy has limited but real effects in America. Expansionary fiscal policy could push the country closer to and even above the Fed's long run growth targets and then the Fed would react slowly to slow down the economy.

Notably, austerity in the U.S. could take the form of cuts in government spending as happened at the State and Local level, or increases in taxes as is the threat with the so called "fiscal cliff".

In Europe, the effects of austerity are even more extreme because the monetary union is not a smooth market. Austerity in Spain, for example, should take some mild pressure off the ECB to increase rates. However, that would promote investment all over Europe-- and because of the fractured banking system, mostly likely investment in Germany.

However, the contractionary effects would happen in Spain. This is why Spain gains nothing from austerity. It makes "room" for private sector investment but has no means to achieve increases in private sector investment. Thus there is simply a hole in the economy.

Now finally there has been some debate over whether or not one should correct for inflation when looking at spending cuts. It depends on what you are trying to figure out. If you are trying to figure out whether or not the cuts are contractionary, then you should ask whether the growth rate of spending went down.

If it did then its contractionary, because the growth rate of something else would have to increase or else the growth rate of NGDP will fall.

Source: Reductions In Nominal Spending Growth Are Contractionary