Friday, March 29, 2013

The good, the bad and... the austeritist!

This post is an attempt to use my rather inexperienced and naive instinct in economics in order to respond to the allegations of the necessity of austerity and tight monetary policy. More specifically, I post my reply to the arguments presented in "The Live arguments of austerity right now: A bestiary" by Mr. DeLong. Please, forgive me if I am wrong.

The first group stresses the importance of tight monetary policy.

"The Jeremy Stein argument": Stein ignores the other element of GDP; the consumption. With lower interest rates households can more easily substitute future for current income. Secondly, risk premium is added to the risk-free rate both when the risk-free is 0% and when it is higher, e.g. 10%, and hence risky assets yield by definition higher returns regardless the level of the risk-free rate. Therefore, bank managers will always prefer more risky assets due to the higher returns they offer anyway. Thirdly, there is always the Basel Accord that requires more regulatory capitals the higher the undertaken risk.

"The Gavyn Davies argument": Although I have never heard of that argument I shall comply with it. Governments can make profits via a growing economic activity both through direct and indirect taxation, in addition to bigger reelection chances. Anyway, I am pretty sure that any given government would prefer a prosperous economy against a stagnant one.

The second group argues for the "contractionary" effects of an expanding fiscal policy at the moment.

"The investment crowding-out argument": No one pays attention to the animal spirits? If demand is poor then the expected income of any given investment will not be adequate to cover the reward of capital, labor and other imputes. So, who exactly is going to invest if the products of his investments will not yield the necessary revenue? Private sector lucks incentives to perform investments and that calls for the public sector to start to invest. Anyway, the available data reveal (US Department of the Treasury; ECB)that in both sides of the Atlantic Ocean long-term interests have declined.

"The future-tax crowding-out argument": First of all, time series of tax revenues as a percentage of GDP do not present significant variation in time, a fact that also stands for the taxation on income, profits and capital gains (IBRD: World Development Indicators). Secondly, if aggregate demand decreases as a response to higher taxation, domestic rates will   fall, capital outflows will increase, domestic currency will be depreciated increasing exports and eventually shift aggregate demand back to where it was prior to the increase in taxes (Mundell- Fleming Model) and we need no to worry for inflation. The same will happen in governments decides to cut its spending instead of increasing taxation. Either way, if business managers can foresee tax increase they can also foresee public consumption reduction.

"The future inflation argument": At the moment the production gap is negative, i.e. we are underachieving. In an elementary AD-AS-LRAS framework, AD shift upwards and to the right as a response to combined increase in public expenditure and money (IS-LM level) crossing the point where AS equals LRAS. In case inflation expectations are generated, AS will depart from equilibrium but eventually negotiators will realize that they have overestimated the inflation and hence AS will return to equilibrium. If you believe that public and monetary policy intervention will not hit the bull's eye, they will eventually do.

"The Alesina argument": Alesina evidences his claims in "Tax Cuts vs. 'Stimulus': The Evidence Is In" (WSJ! What else?) while Romer & Romer (2010) [1] estimate the exact opposite. Call me biased if you like, but I cannot accept the fact that government stimulus is contractionary while public spending cuts are stimulant... It seems extremely absurd to me. 

"The Reinhart-Rogoff argument": Debt is not accumulated if government proceed to spending cuts when growth is achieved (as described in "The future-tax crowding-out argument"). 

The final group claims the government stimulus to be "risky".

"Interest rates will normalize very soon":  DeLong responds:

One counterargument is that at an 80% debt-to-annual GDP ratio with 2.5%/year inflation and 2.5%/year real growth, even financing none of the interest cost but merely balancing the primary budget leads only to a stable and not to an explosive debt-to-annual GDP ratio.
A second counterargument is that the government (within limits) chooses the interest rate it pays on its debts via the reserve and capital requirements it imposes on the banking sector. You can call this "financial repression" and condemn it as not-ideal--as an inefficient allocation of taxes putting too large a weight on finance. But because the government can and will resort to financial repression if necessary, interest rate normalization does not create an emergency: financial repression can be gradually removed as additional revenue sources come on line.
A third counterargument is that countries that get into trouble do so because they find themselves with lots of harder-currency debt--so inflation and devaluation do not boost tax collections and exports and so fail to be the powerful stabilizing forces controlling the debt that they are in countries with no harder-currency debt, and such countries can get into trouble only if they have truly dysfunctional politics.
 The third counterargument depicts what happens in EMU: "dysfunctional politics" voluntarily ignoring the effects of austerity. And the last counterargument by DeLong:

A fourth counterargument is that if America's politics are truly dysfunctional in the 2030s, spending $3 trillion less in the teens to keep the national debt from rising will not help us at all. (a) Right now fiscal policy is self-financing--increasing spending eases the burden of the debt-to-annual-GDP twenty years from now when interest rates normalize and entitlements rise further. (b) Even if fiscal policy is not self-financing, spending an extra $3 trillion now--20% of a year's GDP--for a net additional rise in the debt-to-annual-GDP ratio of 6 percentage points
I could not agree more!

This is my sincere humble opinion! I hope I have convinced you...

[1] Romer, Christina D. ; Romer, Daivid (2010): "The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks". American Economic Review, vol. 100: pp. 763 - 801.

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