Olivier Blanchard Isn't Very Serious: And when you bear in mind that the Very Serious People have been wrong about everything, that’s a very good thing…. Blanchard’s blog post on what went wrong in 2011 is, in fact, totally sensible and on point… contains something of a bombshell….
Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability…
If I have this right, Olivier is suggesting that harsh austerity programs may be literally self-defeating, hurting the economy so much that they worsen fiscal prospects.
This in turn means that the analogy to medieval doctors who bled their patients, then bled them even more when the bleeding made them sicker, is exactly right: austerity reduces growth prospects, leading to calls for even more austerity.
Consider a model with two periods: a present and a future
In the present, we shrink government purchases by ΔG to establish the credibility of our fiscal consolidation program. With a multiplier m amplifying the retarding effect of lower spending on output now and a marginal tax rate τ, we find that we are saving only:
(1 - τm)ΔG
in reduced debt issue.
Now let's look at the future. Some fraction of our extra cyclical unemployment now turns into permanent structural unemployment as discouraged workers permanently drop out of the labor force and those who don't drop out see their skills atrophy to some extent. Call the amount of this hysteresis η: the share of today's temporary reduction mΔG in output that is permanent. Then our tax collections in the future are lower each year by:
and the present value today of future tax receipts is lower by:
where r is the long-run real interest rate on government debt and g is the long-run growth rate of the economy.
The fiscal situation is improved by consolidation today if and only if:
(1 - τm)ΔG > τηmΔG/(r-g)
if and only if the reduction in debt today is larger than the present value of the reduction in taxes in the future. Thus we need:
(r-g)(1/τm - 1) > η
With a zero-lower-bound multiplier of 1.5 and a marginal tax rate of 1/3:
(r-g) > η
g for the U.S. today is somewhere between 2.5 and 3%/year. Over the past two years, as the employment-to-population ratio has held steady, the labor force participation rate has fallen by a full percentage point. That suggests that each year in which cyclical unemployment is stuck 5% above normal sees one-tenth of that cyclical unemployment turn into structural unemployment, an η of 0.1.
That means that as long as the long-term real interest rate at which the U.S. borrows is less than 12.5%/year, cutting government spending this year worsens the long-run fiscal situation.
Why, then, isn't more government spending always good? Because in normal times, when we are not at the zero lower bound, the multiplier m is not 1.5 but rather something like 0.1 or even 0.0.