Tuesday, October 5, 2010

Fiscal Austerity Won't Be Painless

In second term (econ101b), you'll start to learn a lot about macroeconomics, and so the current debate over the macroeconomy and fiscal austerity will start to make a lot more sense after that.  You'll learn about a concept called Aggregate Demand and you'll learn about contributions to it and to economic growth via something called the Circular Flow of Income.  Later in term you'll learn about the money markets, interest rates, and something called the LM curve.

These are basic economic theory concepts, and they allow us to start thinking about the impact of government spending, and help frame the discussions that have been had amongst politicians over the last year relating to austerity.  The Labour party emphasised the impact of spending on Aggregate Demand, saying that big cuts in spending will reduce aggregate demand and plunge us back into recession - less money going around the Circular Flow of Income.  The Tories on the other hand, argued that the government is too big: It "crowds out" the private sector.  We need to cut back government so that the private sector can flourish.

Of course, the problem is putting numbers into these concepts.  They are all well and good as concepts but how big are they?  Labour would argue crowding out isn't that important, particularly at a time of recession and low aggregate demand; Labour would also argue that the multiplier (the factor by which GDP grows given an increase in government spending) is large.  On the other hand, the Tories would argue that crowding out is important, and the multiplier is small.  So who is right?

The Economist reports on two studies which give conflicting viewpoints on this: Welcome to economics!  One research paper, by Alesina and Ardegna, suggests that fiscal austerity can help stimulate growth; the other, from the IMF, says it won't, and picks holes in the Alesina-Ardegna strategy.  The devil is in the details, but what this speaks of most is that, unfortunately, putting numbers on things in economics is very hard work indeed, and often you'll find that people put the numbers on things that they want to see via clever techniques and border on the deceptive, in order to further their case.

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