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The myth of expansionary austerity

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As the U.S. and Europe turn from stimulus to fiscal austerity, claims are heard that spending cuts actually stimulate economic growth. That is the argument heard, not just from the Republicans in the U.S. Congress, but also from the Obama Administration who have pretty much stopped listening to even mainstream macro-economists. And it is the argument of European finance ministers and the European Central Bank who think that a sharp dose of fiscal austerity across the Eurozone need not imperil economic recovery.

However, there is very rarely any such thing as expansionary austerity, according to IMF staff economists.

In a careful review of the historical evidence, they find that, typically, a 1 per cent of GDP fiscal consolidation reduces real private consumption over the next two years by 0.75 per cent, while real GDP declines by 0.62 per cent.

They do allow that the drag on GDP coming from spending cuts can sometimes be offset by positive confidence and interest rate effects if a country is facing an acute fiscal crisis, and that the effects of fiscal contraction can also be offset by a weaker exchange rate, as was the case for Canada under Chretien and Paul Martin.

But, as a rule, the Keynesian position that reduction of government spending reduces short-term effective demand and thus growth and employment is found to be supported by a less selective reading of the evidence than that of Alesina and other right-wing economists.

For Canadians this is surely sobering. We face no fiscal crisis -- our net debt is far below the OECD average. Austerity cannot produce lower interest rates -- short-term rates are near zero and the 10-year Government of Canada bond rate is at a near historic low of under 3 per cent. And, with the dollar hugely over-valued and the U.S. teetering on the edge of another downturn, there will be no offset to fiscal contraction from higher exports this time around.

As we begin the 2012 federal budget debate, Flaherty must be asked why his planned cuts do not risk derailing an already very fragile recovery.

This article was first posted on The Progressive Economics Forum.

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