Nov 06 2012

To continue stimulus or to pursue austerity, that is the question

Note: This post was originally published in August of 2010. It is being reposted today to support a lesson on fiscal policy in my year 2 IB Economics class.

In the seemingly endless and currently ongoing debate over the role of the government in the macroeconomy, there are two main camps: Those who think the governments of the developed economies have not done enough to get their economies out of recession, and those who think they have already done too much, and therefore need to start rolling back stimulus and reducing deficits.

At the heart of this debate are the two macroeconomic schools of thought, the  Keynesian demand-side theories and the classical, supply-side theories. Two intellectuals have emerged in the last several years representing the two sides of the macroeconomic debate. On the demand-side, representing the Keynesian school of thought, is 2008 Nobel Prize winning economist Paul Krugman. Representing the classical, supply-side school of thought is Harvard economic historian Niall Ferguson. These two have squared off in many forums over the last three years, Krugman arguing for more and continued fiscal stimulus to prop up and increase demand in the economy, Ferguson arguing for smaller deficits, lower taxes and less government spending to increase private sector confidence and thereby supply in the economy.

During our long summer break the two squared off once again in the aftermath of a G20 meeting in which the governments of several major economies from Europe and North America announced plans to begin rolling back the stimulus spending they embarked on throughout 2008 and 2009. The reason for increased “austerity measures” (policies that reduce the budget deficit and slow the growth of national debt), argue global leaders, is to reduce the chances of more countries experiencing debt crises like that experienced in Greece this spring.

International investors realized earlier this year that Greece’s budget deficits were a much larger percentage of its GDP than previously thought, and very quickly decided that Greek government bonds were an unsafe investment. Almost overnight the cost of borrowing in Greece shot up above 20%, bringing investment in the economy to a halt and forcing the government to cut its budget, leading to higher unemployment and reduced social benefits for the people of Greece.  If investors were to look at the growing budget deficits in other developed countries and  then suddenly lose faith in other government’s ability to pay back their debts, then a similar crisis could occur in much larger economies, including the UK, Germany and the United States. Hence these country’s apparent desire to begin reducing deficits and rolling back stimulus spending; measures that may just plunge these economies into an even deeper recession than that which they have experienced over the last two years.

The videos below show the leading intellectuals on both sides of the stimulus/austerity debate presenting their arguments. Below each video are discussion questions to help guide your understanding of their views. Watch the videos and respond to the discussion questions in the comment section below.

Video 1 – Krugman argues for continued stimulus:

[youtube]http://www.youtube.com/watch?v=7-pndXGafUg&feature=related[/youtube]

Discussion Questions:

  1. What are the two “profoundly different views of economics” that are being tested as governments begin rolling back the fiscal stimulus packages of the last two years?
  2. What are three characteristics of an economy in a “depression” according to Krugman?
  3. What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?
  4. Why is deflation dangerous according to Krugman?
  5. What is the additional annual cost to the US government of borrowing and spending an additional trillion dollars now? What is the potential additional benefit of more stimulus?

Video 2 – Ferguson argues for austerity and “fiscal regime change”:

[youtube]http://www.youtube.com/watch?v=03CB8pVJkI8&feature=related[/youtube]

Discussion Questions:

  1. Why might the US have to pass spending cuts and tax increases to maintain its “credibility in international bond markets”?
  2. Why would fiscal tightening “choke off the recovery”?
  3. How is the financial crisis in Europe a warning to the US?
  4. How could the “costs” exceed the “benefits” of deficit financed expansionary fiscal policy.
  5. Ferguson proposes a new type of policy that “boosts confidence”. Why will expansionary fiscal and monetary policies fail if private sector confidence remains depressed?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

11 responses so far

11 Responses to “To continue stimulus or to pursue austerity, that is the question”

  1. Anuon 14 Mar 2011 at 10:45 pm

    Austerity measures:

    1. Why might the US have to pass spending cuts and tax increases to maintain its “credibility in international bond markets”?

    To ensure that American bonds remain attractive and sound investments in international bond markets, the US would have to balance its budget (reduce deficit) by passing spending cuts and tax increases.

    2. Why would fiscal tightening “choke off the recovery”?

    Fiscal tightening would reduce disposable incomes and decrease government spending, thus lowering aggregate demand in the economy – causing further disinflation or even deflation and "choking off the recovery".

    3. How is the financial crisis in Europe a warning to the US?

    The financial crisis in Europe is a warning to the US because too much debt caused several European nations' bonds (such as Greece's) to become extremely unattractive to investors and thus reducing international investment.

    4. How could the “costs” exceed the “benefits” of deficit financed expansionary fiscal policy.

    The costs (which in this case would be reduced aggregate demand) could greatly outweigh the benefits of maintaining an attractive bonds offering position to foreign investors if the nation's economy does not recover or enters a deflationary spiral.

    5. Ferguson proposes a new type of policy that “boosts confidence”. Why will expansionary fiscal and monetary policies fail if private sector confidence remains depressed?

    If private sector confidence remains depressed, expansionary fiscal and monetary policies will fail as aggregate supply in the economy remains at low levels and the nation does not move towards full employment.

  2. Anuon 14 Mar 2011 at 11:01 pm

    Krugman's argument:

    1. What are the two “profoundly different views of economics” that are being tested as Governments begin rolling back the fiscal stimulus packages of the last two years?

    The two "profoundly different vies of economics" are the Keynesian view that Government spending is key for economic recovery after recessions/depressions/deflations and the classical supply-side view which calls for balanced budget and greater attraction for private investment.

    2. What are three characteristics of an economy in a “depression” according to Krugman?

    The characteristics of an economy in depression according to Krugman are high levels of unemployment, low levels of consumption and low growth.

    3. What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?

    Budget austerity refers to governments maintaining balanced budgets. Krugman things this should not be the first priority of policymakers as kick-starting the economy again and encouraging growth are more important in the short run.

    4. Why is deflation dangerous according to Krugman?

    Deflation is dangerous according to Krugman because as prices drop, both consumers and investors are both more likely to 'hang on to lots of cash' instead of spending and investing in the economy – keeping aggregate demand in the economy low.

    5. What is the additional annual cost to the US government of borrowing and spending an additional trillion dollars now? What is the potential additional benefit of more stimulus?

    The additional cost is 17 Billion dollars in increased interest, but the additional benefit is a recovery of the economy.

  3. Adrian Mladenovon 15 Mar 2011 at 1:33 am

    What are the two “profoundly different views of economics” that are being tested as governments begin rolling back the fiscal stimulus packages of the last two years?

    The two different views are the Keynesian one, and the classic supply view. The keynesian view states that there should be a lot of government spending during a recession to pull the country out of recession. The classical view consists of lower taxes, and lower government spending in order to free the private sector to allow for more private investment.

    What are three characteristics of an economy in a “depression” according to Krugman?

    High unemployment, pressure towards deflation, and weak periods of recovery or slums.

    What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?

    Budget austerity= bringing deficits down, balancing budgets. He thinks it shouldnt be first priority because he thinks that there should be encouragement brought to the people through government spending.

    Why is deflation dangerous according to Krugman?

    Because deflation gives the incentive to households to save their money, and not invest or consume in the economy. This means a downward shift in AD which will result in a downward deflationary spiral.

    What is the additional annual cost to the US government of borrowing and spending an additional trillion dollars now? What is the potential additional benefit of more stimulus?

    ?

    Why might the US have to pass spending cuts and tax increases to maintain its “credibility in international bond markets”?

    Because the increased government spending hasn't worked well enough in the past, and deficits are getting too high, therefore they need to lower deficits in order to make sure bonds stay attractive.

    Why would fiscal tightening “choke off the recovery”?

    It would knock the AD curve downwards, therefore deflation would occur, and halt the recovery.

    How is the financial crisis in Europe a warning to the US?

    Because countries like Greece went into a stage where their bonds were unattractive.

    How could the “costs” exceed the “benefits” of deficit financed expansionary fiscal policy.

    If the lesser consumption, and lower AD exceed benefits gained while trying to lower deficits.

    Ferguson proposes a new type of policy that “boosts confidence”. Why will expansionary fiscal and monetary policies fail if private sector confidence remains depressed?

    It will fail because there will be still high unemployment, and AD will still remain low. There will be no incentive for households to spend, and firms to invest if the private sector remains depressed.

  4. Pilar Mulleron 15 Mar 2011 at 1:04 pm

    What are the two “profoundly different views of economics” that are being tested as governments begin rolling back the fiscal stimulus packages of the last two years?

    One view is the Keynes view where the idea is that government should spend and thus increase government spending. In the classical view, the market should be more or less be left to its own (laissez-faire) and then in the long-run the result will be again economic equilibrium.

    What are three characteristics of an economy in a “depression” according to Krugman?

    The three characteristics of an economy in a depression are extended periods when an economy does badly, constant pressure toward deflation, and high unemployment.

    What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?

    Budget austerity is the goal of the G20 nation to bring deficits down. Krugman says that this should not be our first priority because first we should help the people and then start worrying about bringing the deficits down.

    Why is deflation dangerous according to Krugman?

    Deflation (when prices are falling) is so dangerous because when the people are not consuming enough, deflation makes holding on to cash look like an attractive way. Krugman says that some inflation is good for the economy.

    What is the additional annual cost to the US government of borrowing and spending an additional trillion dollars now? What is the potential additional benefit of more stimulus?

    Its cost would only be an additional 17 billion dollars to the interest rates. Furthermore, an additional trillion dollar spending would make a big difference because it could lower the unemployment rate, increase the long-run prospects. He says that government spending is better than doing nothing in order to improve the long-run budget position.

  5. Graham N.on 17 Mar 2011 at 12:00 am

    1. The two profoundly different view of economics are essentially classical and keynesian economics. One calls for stopping government spending to reduce the risk of credit crisis while the other calls for continued spending to prevent further economic problems.

    2. According to Krugman, a depression is an extended period when the economy does poorly, when unemployment stays high, and when there is constant pressure towards deflation.

    3. "Budget Austerity" is the reduction of budget deficits. According to Krugman, this is a bad idea as it does not reduce unemployment.

    4. Deflation is dangerous because it reduces the propensity to consume. Money becomes worth more saved for the future than it does currently.

    5. The additional cost of $1 trillion is $17 billion per year to the US government. The potential benefit of more stimulus is a return to the full employment level of demand.

    1. The US might have to pass spending cuts and tax increases to maintain "credibility in international bond markets" if investors believe that the United States is at risk of defaulting due to a high level of debt.

    2. Fiscal tightening might "choke off the recovery" if the reduction in government spending and consumption decreases AD enough to increase unemployment or put the country into a deflationary spiral.

    3. The fiscal crisis in Europe is a warning to the US because the any country that continues to spend without reigning in deficits will eventually face a credit crisis.

    4. The "costs" of expansionary fiscal policy could outweigh the "benefits" if it leads to a fiscal crisis and the resulting "death spiral".

    5. Expansionary fiscal policy could fail if the private sector remains depressed because without an increase in one of the determinants of aggregate demand, the economy cannot improve.

  6. Uday Srinivasanon 17 Mar 2011 at 1:11 am

    @Graham's last bit

    But expansionary fiscal policy includes increasing government spending, which, by definition, will increase AD. Whatever happens, the policy will help and the economy will at least not worsen as much.

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