Austerity Agonistes: Why Left Wing Economists' Warnings against Austerity Programs are Wrong

September 16, 2010

One of the key signaling devices for international investors is how a government behaves under financial duress -- how it balances the demands of its debtors with those of its welfare recipients.  Announcements of lower spending and higher taxes tell investors a country is willing to go to great lengths not to default on its debt obligations.  If the government instead focuses on preserving its welfare state and public employee benefits, investors know default is more likely and will shy away from that country's bonds, says Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University.

The notion that austerity is bad and stimulus is good rests on the Keynesian theory that if the government spends a lot of money, that money will create more value in economic growth.  This purported increase in gross domestic product is what economists call the "multiplier effect."  It is a nice story, but like most fairy tales, it has scant basis in reality, says de Rugy.

  • In a paper published by George Mason University's Mercatus Center, economists Robert Barro and Charles Redlick showed that in the best-case scenario, a dollar of government spending produces much less than a dollar in economic growth -- between 40 cents and 70 cents. 
  • Barro and Redlick also looked at the economic impact of raising taxes to pay for spending increases.  They found that for every $1 in tax-financed spending, the economy actually shrinks by $1.10. 
  • In other words, greater spending financed by tax increases damages the economy.

The understandable temptation to take action in a time of recession should not lead lawmakers down unproductive paths.  Now is the time to tighten spending, no matter what some American economists might say, says de Rugy.

Source: Veronique de Rugy, "Austerity agonistes:  why left-wing economists' warnings against austerity programs are wrong," Reason Magazine, October 2010.

For text:

http://www.thefreelibrary.com/Austerity+agonistes%3A+why+left-wing+economists'+warnings+against...-a0236332418

For study:

http://www.nber.org/papers/w15369.pdf

 

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