(WASHINGTON POST) Matt O’Brien — There might be a worse idea than cutting spending during a depression, but I doubt it.
The fundamental economic question of the last five years has been a simple one: how much does stimulus work? The answer, according to a new paper byDaniel Riera-Crichton, Carlos Vegh, and Guillermo Vuletin, is much more than we previously thought. And that means austerity has also hurt more than we thought — so much so that it might even be self-defeating.
That’s right: cutting spending in a slump might actually make debt problems worse.
It’s all about the fiscal multiplier. Stimulus, you see, is measured by how much one dollar of government spending increases GDP. But in a normal economy, it doesn’t. That’s because the Federal Reserve has its inflation target that it’s determined to hit (or at least not overshoot). Government spending, though, can flood the economy with money, raising prices in the process. So the Fed, in turn, would either raise rates to offset this spending it doesn’t want, or wouldn’t cut rates like it otherwise would have.
Either way, the Fed’s actions would keep the economy from being any bigger with more government spending than it would be without it.
But this calculus changes when there’s a recession, especially if interest rates are at zero. In that case, the Fed wouldn’t want to neutralize stimulus spending. So GDP would grow at least as much as spending does — what economists call a multiplier of one — and maybe more since there could be spillover effects.