Tar or Honey? Cure for Recession Debate Linas Čekanavičius Vilnius University

Longstanding debate SPENDING or AUSTERITY should be employed ...whether government SPENDING or AUSTERITY should be employed in order to overcome financial downslide and to set economy straight?

Two opposite schools: Spending (Honey): fiscal stimulus via increased government borrowing and spending and/or tax cuts Austerity (Tar): budget deficit reduction via public spending cuts and/or tax hikes

How does Spending work? When the Crisis hits... Y = C + I + G + NX

Government Purchases Multiplier How does Spending Work? Y = C + I + G + NX P AD AD* Government Purchases Multiplier AS Y2 Y1 Y (Q)

Govt Purchases Multiplier Works best when: Money are spent on domestic goods Short-run prices are fixed

Total Fiscal Rescue Package as a Percentage of GDP in 2009 14

Shortcomings of Spending Economic growth Time lags Debt Spending increases vs. tax cuts Shortcomings of Spending Time lags Spot the bastard-> Take action -> See effect Debt Consuming today at the expense of tomorrow

Austerity?.. Situation in which there is not much money and it is spent only on things that are necessary (Merriam-Webster Dictionary) Source: The Telegraph

Definition Actions taken by the government, during a period of adverse economic conditions, to reduce its budget deficit using a combination of spending cuts and/or tax rises (Financial Times Lexicon)

Budget deficit Countries exceeding 90% of their debt-to-GDP ratio demonstrate significantly slower economic growth rates Public debt Revenues Expenditure

Budget deficit Revenues Tax hikes Spending cuts Expenditures

How does it work? Spending cuts Tax increases Output growth …make businesses anticipate tax cuts in the future …lower interest rates Encourage investment Output growth

Austerity measures

The Good – Spending Cuts Features the most growth-fostering austerity policy politicians less able to misallocate resources Empirical evidence economy-expanding fiscal adjustments are better served by spending cuts, rather than tax increases Case study: Iceland, having cut spending by more than 4% of GDP, reached pre-crisis levels in 2012

The Ugly – Tax Increases Features expansionary effect depends on the current standpoint on Laffer’s curve Empirical evidence “fiscal consolidation through spending cuts is less contractionary than [...] through tax increases” Case study: France undertook several tax burden increases between 2007 and 2012 Its economic recovery was rather sluggish

The Bad – Mix of Two Features Empirical evidence: not so bad? “spreads the pain across [both] the public and private sectors” Empirical evidence: not so bad? combination of both options leads to economic growth if followed by appropriate growth-enhancing reforms Case study: Estonia engaged in both sharp public spending contraction and substantial tax increases Its economy exceeded pre-crisis level in 2014

Fallacy of composition If everybody saves, who spends? Technical remark Consumers cannot project future cash flows Increased inequality Smallest income earners lose the most What is wrong with Austerity?

Conclusions Mechanism Conditions Limitations S: Govt purchases multiplier boosts Mechanism A: Expectations drive behaviour S: Money spent on domestic goods; constant prices A: Rational decision-makers Conditions S: Time lags & debt A: Income inequality; not working if implemented simultaneously among trade partners Limitations

What is recovery goal: Status quo ante boom? Status quo ante downslide? Might be not the best policy choice, as the euphoria of the “boom and boost” period could have easily resulted in the wrong investment decisions and therefore in the misallocation of resources Status quo ante boom?

Thank you for your attention!