Karl’s post yesterday led to an important exchange about the possibility of self-defeating deficit reduction, with particularly important contributions from Michael Burke and Michael Taft. If multiplier and automatic stabiliser effects are sufficiently large, the understandable concern is that cuts in the discretionary deficit could actually raise the deficit overall. We end up with the worst of both worlds – a deeper recession and a larger deficit.
Effectively, the argument is that the deficit reduction measures slow the economy, and this leads to automatic stabiliser effects (falling tax revenues and rising expenditures) that offset the discretionary effect (i.e. the underlying change in the deficit holding GDP constant).
While plausible, I believe the claims for self-defeating deficit reductions are wrong – or at least wrong in the context of the simple (and I believe essentially correct) model that I think all the main participants in the debate are using. I sketch this model here. Using the model, it can be demonstrated that a discretionary deficit cut will lower the overall deficit for any (non-negative) values of the deficit multiplier and automatic stabiliser coefficient. Moreover, it can be shown that the deficit as a share of GDP also falls with a reduction in the discretionary deficit, even as this reduction slows the economy through a multiplier effect.
Of course, a simple model cannot provide the last word on the issue. But hopefully it will at least help us pinpoint better the sources of the disagreement.
Those arguing against the need for austerity point out that the underlying deficit has grown with previous rounds of austerity. While I agree that these measures have slowed the economy, I do not believe that they have actually caused the deficit to rise. Unfortunately, there are other contractionary forces at work, not least the overhang of debt that is curbing business and household spending and also bank lending. With bond yields where they are, I assume we all agree that we cannot avoid a bailout/default without putting the deficit quickly on a downward path. I don’t see we have any choice now but to pursue tough deficit reduction measures. It is not going to be pleasant.