Thursday, July 01, 2010

Why Austerity Will Strangle Growth

Here's a breakdown by the Dallas Fed of the drivers of the current recovery. Inventory adjustments represent an unusually large proportion of the total improvement, and now end sales are catching up with the reduced inventory backlog. As Mark Thoma notes:
Given this worrisome short-run outlook for GDP growth, and hence for employment, why do some people think cutting stimulus, which is what cuts to the deficit do, is the way to enhance the recovery?

Output can be written as Y = C + I + G + NX (output = consumption + investment + government spending + net exports). If we cut the deficit through reductions in spending and increases in taxes, we know G will go down (as spending falls) and that C and I will also fall (from tax increases on consumers and businesses). But somehow, the story goes, as GDP and employment are falling, confidence will go up so much that C, I, and perhaps NX will go up more than enough to compensate for the fall, and then some. However, if the confidence effect doesn't appear and generate very strong effects, and it's unlikely that it will despite the wishful thinking from some, deficit reduction makes things worse in the short-run, not better.

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