Paul Krugman estimates that €1.00 of spending cuts in Europe produces only €0.40 of debt reduction relative to baseline and produces a €1.25 fall in production in the short run.
Assuming a long-term real interest rate on secure government debt of 4%/year, that means that austerity now improves the government's long-run fiscal condition only if the η--the hysteresis shadow cast on future European output by the current downturn--for Europe right now is less than 0.014. If even 3 out of 200 workers laid off for a year during this depression never return to work and 3 out of every 200 machines not installed in factories are never installed, then austerity is a bad bet on pure fiscal-stability grounds alone.
Paul Krugman:
Austerity And Growth, Again: Kash has a nice summary of… the new Eurostat numbers…. So I thought I’d do a bit more…. Let’s… create a crude adjusted measure of austerity. I calculate the amount the budget balance “should” have changed as 0.45 x (growth from 2009 to 2011 – 4%). In this formula, 0.45 is the average share of government revenue in GDP in the euro area, so this is a rough measure of revenue effects of growth; I’m just assuming that 4 percent would represent normal growth for a euro country over 2 years. And I estimate austerity as the difference between the actual change in budget balance and this predicted change.
So this is a kind of E. Cary Brown computation…. What do we get… [?] An apparent multiplier of around 1.25, not out of line with other estimates.
It’s worth noting that this also implies that 1 euro of austerity yields only about 0.4 euros of reduced deficit, even in the short run. No wonder, then, that the whole austerity enterprise is spiraling into disaster.
