Thursday, July 1, 2010

Is it the Time for Austerity?

Most mainstream economists' views either fall into one of these camps, or mix a few of these arguments:

1. Yes: Keynesian economics is wrong, and there was never a need for fiscal stimulus.
2. Yes: The recovery is underway, so governments can now withdraw stimulus.
3. Yes: Governments can't afford to keep stimulating the economy, either because: a) investors will soon balk at lending them money; or b) when the recovery gets underway, interest rates will rise, and big debts will prove too large a burden.
4. Yes: Monetary policy can still do more to stimulate the economy, and should do the job now that the initial fiscal stimulus has prevented a depression.

5. No: With short term interest rates at 0%, monetary policy has hit its limit, so fiscal policy is needed.
6. No: For many countries like the U.S., Canada and Germany, governments can borrow very cheaply. Thus the benefits of austerity are little (investors won't balk at lending them any time soon), while the costs could be tremendous if fiscal restraint thwarts recovery.
7. No: The governments that can borrow cheaply now should take advantage of the situation and invest in the future (education, infrastructure, etc.).

I'm not a macroeconomist, but I do know a thing or two about this topic. Of these arguments, I'm most sympathetic to 3 and 5. Basically, I'm torn: the economy is still way below potential, and the recovery in most countries does not look robust. Monetary policy can probably do more by driving down long-term interest rates, but I don't think that's enough. I do believe that fiscal stimulus works, but there are two major drawbacks to it:
- If too much debt is accumulated, that can nip recovery in the bud: when the economy turns up, interest rates will rise, and the government will run into huge trouble. So even though interest rates are low now, fiscal stimulus still carries a large cost.
- If intense stimulus lasts for too long, the structure of the economy may shift toward sectors that cater to the government; this would slow recovery, as structural change back to "normal" would be required. Stimulus through tax cuts rather than spending can mitigate this problem, but tax cuts fail if people simply save the money.

Overall, since the recovery is fairly strong in Canada, the government should probably adopt a wait-and-see attitude, which it seems to be doing. However, the right policy for Canada is probably not the right one for the rest of the Western world, so Harper may have erred in urging restraint from other countries...

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