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Tar or Honey? Cure for Recession Debate Linas Čekanavičius Vilnius University Longstanding debate ...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 How does Spending Work? Y = C + I + G + NX P AD* AD AS Y2 Y1 Y (Q) Government Purchases Multiplier 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 Economic growth 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: TheTelegraph 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 Expenditures Tax hikes Spending cuts How does it work? Spending cuts Tax increases • …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 • “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? What is wrong with Austerity? Technical remark Consumers cannot project future cash flows Increased inequality Smallest income earners lose the most Conclusions Mechanism • S: Govt purchases multiplier boosts • A: Expectations drive behaviour Conditions • S: Money spent on domestic goods; constant prices • A: Rational decision-makers Limitations • S: Time lags & debt • A: Income inequality; not working if implemented simultaneously among trade partners What is recovery goal: 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!