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One Man's Fiscal Austerity is Another's Economic Prosperity?

Politics / Economic Austerity Apr 11, 2011 - 03:45 PM GMT

By: Paul_L_Kasriel


Fiscal austerity is all the rage these days in the developed economies. The proponents of fiscal austerity argue that it will lead to economic prosperity. The opponents of fiscal austerity argue that it will lead to poverty. Who is correct?

If the government decides to spend less, then, all else the same, it will need less funding. This, in turn, implies that the government will either cut back on its current taxation or cut back on its current borrowing. The former recipients of the cut-back government expenditures - government employees, contractors and/or transfer-payment recipients - will indeed experience a decline in their spendable funds. However, taxpayers and/or previous government bond purchasers will find themselves with extra spendable funds. What will they do with their extra spendable funds?

There are four things they can do with their extra spendable funds. (1)They can spend them on currently produced goods, services and physical assets. This would lead to an increase in the income of the producers of these goods, services and physical assets. (2) They can spend them on existing physical or financial assets. This would transfer spendable funds to the sellers of these existing assets, who would then have a decision to make with regard to how to dispose of their extra funds. (3) They can spend them on newly-issued financial assets. Presumably the issuers of these new financial assets are raising new funds in order to engage in some new spending. (4) The taxpayers and previous government bond purchasers who now find themselves with extra spendable funds might decide just to hold on to the additional deposits that they find themselves with. The fourth choice, hold on to the additional spendable funds in the form of deposits, is what economists refer to as a decrease in the velocity of money.

Only under option four would a cut in government spending result in a net decline in total spending in the economy. Under options one, two and three, there is simply a redistribution of spending in the economy, not a net decline in spending. Hence, a cut back in government spending, while resulting in one man's austerity, simultaneously results in another man's prosperity.

Let's take this analysis one step further. Let's assume that the cut back in government spending is matched by an increase in other private spending that results in an increase in the productivity of the future labor force. For example, suppose there is a cut back in government transfer payments to retirees, with these funds now being directed to business spending on state-of-the-art capital equipment. While total current spending in the economy is unaffected by this redistribution of spending, total future spending might be advantageously affected. All else the same, future workers using state-of-the-art equipment will be more productive. In turn, this means that the economy in the future would be able to produce more goods and services than otherwise would have been the case. In this case, one man's current austerity potentially leads to everyone's future prosperity.

I should emphasize that there is no guarantee that the funds "saved" by the cut in government spending will be spent by the private sector in a way that will enhance the productivity of the future labor force. Moreover, some government spending could conceivably enhance the productivity of the future labor force more than private-sector spending would. For example, government spending on the health care of low-income children might lead to healthier, and, therefore, more productive future adult employees. If there were a cutback on government spending on the health care of low-income children and the "savings" were spent on granite kitchen countertops, it would be difficult for me to argue that this redistribution of spending in the economy would lead to higher productivity of the future labor force.

By Paul L. Kasriel
The Northern Trust Company
Economic Research Department - Daily Global Commentary

Copyright © 2011 Paul Kasriel
Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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