Government Budget Cutting SLOWS the Economy – That’s Why It’s Called Contractionary Fiscal Policy

America’s attention has been focused lately on the unnecessary debate in Congress over the debt-ceiling law.  Part of the motivation (at least the vocalized motivation) for cutting the deficit and trying to limit the national debt, according to both Republicans and the President, is that supposedly government deficits are holding back the economy. They assert that cutting the government’s spending will somehow stimulate the economy.  This is what all that Republican rhetoric about “jobs-killing spending” is about.  In more formal terms it’s referred to as a policy of “austerity”.   But it’s more than flawed thinking.  It’s flat out wrong.  Cutting government spending when there is significant unemployment and excess capacity will not stimulate the economy.  It will cause the economy to slow down and contract further.  That’s why we economists call it “contractionary fiscal policy”.

GDP, the total value of all goods and services produced, is how we measure the economy.  We can count GDP two ways.  Either we add up the total spending in the economy or we add up the total incomes (wages and profits, mostly).  Government spending is part of that spending – close to 25% in fact.  If the government spends less, it means less GDP.  It also means less income for people because what is one person’s spending is another person’s (or business’s) income.

Across the ocean, the British fell for this silly make believe idea that government austerity would create prosperity.  In 2010 they elected a Conservative government (actually a Conservative-New Democrat coalition).  The Conservatives, led by Prime Minister Cameron and Chancellor George Osborne (equivalent of the U.S Treasury Secretary), began to implement sharp cuts in government spending in mid-2010.  The results have been clear.  And bad.  The Guardian reports the results.  The British economy actually shrank by 0.5% in the 4th quarter of last year.  It barely avoided an official recession when growth in the 1st quarter with 0.5% growth. (the Brits define a recession as two negative quarters).  Now the 2nd quarter numbers are in and the economy is basically dead in the water:  0.2% annual growth rate.

 

Yes, contractionary fiscal policy, cutting the budget, is, well, contractionary. It makes things worse.  If you want to reduce government spending, do it when you have full employment, not when unemployment has been running over 9% for more than two years.  The examples are legion. Britain is only one. Three years ago Ireland thought it could budget-cut it’s way out of the Great Recession/Financial Crisis.  It only made things worse and grimmer in the emerald isle.  Austerity is making things worse for Greece.  There’s really no end to the examples.  What’s missing is any evidence from a developed country that austerity when unemployment is high actually helps.