Why Stimulus Spending Works and Austerity Fails

23 Nov

What’s the best way to solve a country’s economic troubles? Stimulus or Austerity?

Let’s start by thinking about how people (and businesses) make money. The basic rule (thank you, Charles Dickens) is :

  • Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness.
  • Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery

Some people will say “Of course, this means you can’t spend your way to prosperity! Austerity must be the key!!” That’s completely the wrong lesson to learn. After all, for me to earn my twenty pounds, someone else has to spend it. The last thing I want is for my employer (or his customers) to go on an austerity drive. Who, then, would pay my salary?


  • The path to my prosperity, according to the quote above, is for me to spend less, but others to spend more.
  • Obviously, not everyone can do this simultaneously, or we’d all be broke.

Anyway, Charles Dickens got it a little bit wrong. There are ways to spend that would actually increase wealth.

  • I could spend money on an old house, spend more money renovating it, then sell it at a handsome profit.
  • I could spend money on my education, gaining skills I need to get a better job later.
  • A company could spend money hiring valuable staff members, or advertising, or setting up better facilities.
  • A government could spend on infrastructure or employee productivity, making companies more profitable and increasing its tax take.

This kind of spending is often called “investment”. I’ll use that word in this post.┬áSo in the austerity vs spending debate, we need to keep these points in mind :

  • It’s not clever to be austere about investment spending.
  • Even when it might pay to be austere, it doesn’t help if everyone else is austere as well.
Right, now that we know that, let’s look at whether government stimulus or austerity an save an economy. The first thing to notice is that “the government” is the government, but “the economy” is, largely, the private sector. There’s no a priori reason to think that government austerity will help the private sector. In fact, on the face of it, the idea is silly. Certainly, government austerity won’t help government employees. At the best of times, all government austerity could do is help government finances.
It’s no wonder Spaniards, Italians and especially Greeks are protesting against the austerity measures being forced on their countries. I guess the conversation might go like this :
  • Worker : I protest these Austerity measures. Since the government cut back spending, I’ve lost my job. So have many of my friends.
  • Government : We have to cut spending, to reduce our deficit.
  • Worker : why do you have to reduce your deficit?
  • Government : Otherwise, we’d have to borrow more money.
  • Worker : and why, pray tell, is that a problem?
  • Government : If we borrow too much, the interest rate we pay might become higher.
  • Worker : so what? Why should that bother me?
  • Government : If we have to pay too high an interest rate, we’d be forced to cut spending in other areas. People might lose their job.
  • Worker : You already did that, and I did. At this rate, it looks like I won’t be paying any tax this year.
Anyway, as we’ve seen already, it’s no use if everyone is austere at the same time. If Spain, Greece and Italy are going to benefit by cutting spending, Germany or France or someone else needs to increase spending at the same time. So far, no sign of this. Chancellor Merkel seems to think the idea is laughable. I guess she doesn’t know much economics.
So, even at the best of times, government austerity or spending has no effect on the economy. However, we are now living in an unusual time. A time when government austerity is harmful, and government spending hugely beneficial, in most developed countries.
On the face of it, after all, an extra dollar spent by the government puts an extra dollar into the pocket of some government employee or contractor. Some of this dollar then goes to the pocket of a retailer, or a supplier, or whatever. It then gets spent again and again. It’s easy to imagine that the taxes extracted from this dollar as it goes round and round could eventually restore the whole dollar to the government’s coffers, ready for them to spend it again.
Unfortunately, it’s not that simple. If a contractor is earning some dollars on a government project, then he’s not earning those same dollars on someone else’s project. That someone else, if they exist, will have to pay more for someone else to do the job, or make do without. The net effect of the government’s spending is made up of three parts
  • The boost to the economy from the money that was spent,
  • The loss to the economy due to the resulting inflation (or, if the reserve bank squishes inflation by raising interest rates, the increase in what it costs to spend money instead of saving)
  • The loss to the economy due to the money not spent.
The second and third effects together almost cancel out the first, so during normal economic times, the government can’t boost the economy by spending. Likewise, they can’t hurt it by cutting spending, as long as the changes are not too drastic, not too sudden.
During normal economic times, companies who lose government contracts find business elsewhere. Employees retrenched from government departments find work in the private sector. Painful, but not horribly so.┬áDuring normal economic times, the government can’t affect the economy or unemployment through spending.
However, sometimes, the economy enters a slow time – when a government contract is canceled, there’s no someone else to take over as a customer or employer. Usually, this is not a problem – the reserve bank can try to stimulate the economy by lowering interest rates. If they do so, the government’s austerity still has no effect.
In 2008, however, there was a recession so severe that in many developed countries, reserve bank interest rates hit zero. They couldn’t lower it any further. The reserve bank suddenly became powerless to stop unemployment from climbing and GDP from going down. This is still the situation in most developed countries with reserve banks – Australia being a notable exception.
In this situation, if the government spends an extra dollar, they aren’t taking away a contractor or employee from some private sector job. They are putting a someone to work who would otherwise have remained unemployed and idle. Therefore, in this situation, whenever the government spends money,
  • The economy benefits directly from the money spent
  • There’s no resulting inflation, since the government’s not bidding against anyone else for the use of people or resources
  • Likewise, the government spending doesn’t lead anyone to stop spending, as it does during normal times.
So, since 2008, any government spending in the USA, the UK, and many other developed countries would have had a direct positive impact on the economy, with precious little downside. Likewise, the spending cuts now being imposed have a direct negative effect, with precious little upside.
But you don’t need theory to know this. The UK has been touting (and implementing) austerity for over a year, and their economy is not improving. Europe is imposing austerity on struggling economies, with disastrous results. The US is cutting spending, and the economy there is not improving.
Both theory and evidence say that austerity is bad, stimulus is good. If you won’t believe the theory or the evidence, what will you believe?

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