Stimulus vs. Austerity: Which works best?

For many years, economists and policymakers have been locked into the ‘Austerity or Stimulus’ debate . These two seemingly contrasting policies both have their flaws: Stimulus policies run the risk of large budget deficits while austerity policies can have contractionary effects on the economy.

Austerity is based on the pro-cyclical fiscal policy; for the economy to experience a ‘boom’, government should spend more and reduce taxes but when the economy is in downturn, governments reduce spending and increase taxes. Austerity has been imposed in many countries following the recent global recession. Countries such as Greece and Spain, with huge public debts, are undertaking strong austerity measures.

However, there is a common misconception that high public debt was one of the causes of the recession and the public debt could lead to a bigger recession in the future. In actual fact, it was high private sector debt that was one of the contributing factors to the economic slump – public debt was merely a consequence. The key problem with austerity cuts lies in the aggregate demand of the economy. As the private sector begins to cut spending through wage cuts, redundancies, for instance, the level of demand in the economy falls because of consumer’s falling real income. This is where the public sector needs to step in and balance the economy out. However, if the public sector makes cuts as well, it creates a downward spiral in demand within the economy and worsens public debt. This has been seen in Spain and Greece, where instead of playing a stabilising role, the fiscal policy has ended up exacerbating the dampening effects of private sector cuts. Although running high deficits is not healthy from an economy, a country needs to aim to increase aggregate demand which will, over time, balance out the budget.

Stimulus measures aim to kickstart an economy through injections of money into the economy. This key Keynesian idea of a counter-cyclical fiscal policy has been used by governments since the Great Depression. Keynes claimed that the “boom, not the slump is the right time for austerity at the Treasury”. The concept of the stimulus package aims to increase consumer spending which, in turn, increases firm’s revenue and profit. As firms increase profits, they seek to expand thus creating new jobs and protecting the old ones. This entire system works together to create a robust economic cycle and most importantly, it leads to an increase in tax revenue for the government, which, in turn, reduces the deficit.

It is evident which fiscal policy works by looking at what the successful countries are using. The most prominent users of the stimulus policy are China and USA. They are both experiencing economic growth and over the long term, will be able to reduce their deficits through stimulus. On the other hand, countries in Europe and, that embrace austerity are witnessing high levels of unemployment, greater unwillingness for banks to lend and low consumer confidence.

Overall, austerity policies only target short term fiscal deficits and debt to GDP ratios, and as seen in Spain, it leads to exacerbated capital flight in countries that need demand. Stimulus policies, when implemented correctly and at the right time, can help reduce deficits far quicker than austerity could. Therefore, rather than follow pro-cyclical policies of the conservative economists, we need to embrace the counter-cyclical ones.

Contributed by Anurag Chandrasekhar

One thought on “Stimulus vs. Austerity: Which works best?

  1. other significant point is that with ouutpt declining prior to currency collapse, and that decline being arrested and partially reversed shortly after collapse, it is not the large depreciation as such that is costly but the factors leading to the currency collapse. I’d suggest it’s the collapse in what Marx would term fictitious capital’, or in the language of this credit crunch’ the revelation that the value of banks’ capital assets (debt, derivatives and real estate) had been vapourised, becoming toxic assets’ on their balance sheets.You only answer your own question by insinuation, misrepresenting the BIS paper’s argument on currency collapses and ouutpt: Is the BIS an agent of financial terrorism itself? Because clearly death and destruction for an economy can’t be considered a good thing’, unless of course you’re working for those forces that are encouraging death and destruction. Is that what the BIS up to? The BIS paper doesn’t argue what you suggest, and they’ve actually been speaking out against the forces you insinuate they’re agents of: I presume you mean TBTF banks and other large private financial institutions since you go on to identify Goldman Sachs and derivative trading between Wall St banks. The BIS is arguing for tighter regulation of those banks, their capital base and balance sheet manipulation (Basel III):Submitted by Tyler Durden on 05/31/2010 As the FT reports, according to a soon to be released report by the bank’s Chief Economic Advisors Stephen Cecchetti, Banks are exaggerating the economic effects of the regulations they are likely to face in the coming years. While his focus is on the implications of the passage of the Basel III treaty, and to preempt counter lobbying by the bank themselves, his argument can be extended to every instance in which banks present scenarios of collapse should they not get their way: as Cecchetti points out: the banks’ “doomsday scenarios” were based on their assuming “the maximum impact of the maximum change with the minimum behavioural change.” This is a huge point, as it means that even the failure of the TBTF banks could have been mitigated in the context of a controlled (and even uncontrolled) bankruptcy, and the only reason they were bailed out was to preserve the equity interests and the existing management team, period. This also means that the Fed and Treasury are nothing but vehicles for perpetuating Wall Street’s status quo, as we have claimed from the very beginning.Isn’t that a point made repeatedly in TAM etc? So I think if Goldman Sachs create oil-goop collateralised obligations and sell them on Wall St. and sell it on an exchange, sell it to another bank and that bank sells it to another bank and on and on it goes. , the BIS would tend to frown upon those being counted as part of the capital base on those banks’ balance sheets. I think Marx would probably count them among the fictitious capital’ circulating within an economy, whose value is likely to vapourise at the turn of a business cycle.

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