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

2. 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?

3. 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

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

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

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

7. Total Fiscal Rescue Package as a Percentage of GDP in 200914

8. 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

9. 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

10. 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)

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

12. Budget deficit
Revenues
Tax hikes
Spending
cuts
Expenditures

13. 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

14. Austerity measures

15. 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

16. 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

17. 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

18. 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?

19. 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

20. 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?

21. Thank you
for your attention!