Economic growth is not contractionary, and other confusions about stimulus and spending

Let’s say that private gdp is 100 and government spending is 100.  Gdp then suddenly goes up to 200, so government spending as a percentage of gdp falls from 50% to 33.3%.  This is not a contractionary event.  It is fully possible to argue “government spending should go up too, to slot more public goods into the larger output,” but the initial change is expansionary, even though government spending as a percentage of gdp took a steep dive.

Let’s say that private gdp is 100 and government spending is 100.  Government spending stays the same in nominal terms but there is overall price inflation from a nominal change.  It is fully possible to argue “government spending should go up too, to restore the percentage of public goods in national output,” but the initial change is again expansionary in macroeconomic terms.  Nominal values are up.

In other words, when judging whether fiscal policy is contractionary or expansionary in macroeconomic terms, we do not automatically adjust for percentage of gdp and inflation.  Start instead by looking at nominal government spending, and then perhaps take a glance at nominal gdp or related measures.  The theory, after all, is about nominal values, most of all in the short run.

If you wish, I could construct a similar exercise for population or an increase in the labor force and come out with a similar result.

There is one case you could embrace (though I don’t see the critics doing it).  Say gdp is 100 and government spending is 100.  A negative real shock lowers real gdp and creates some price inflation.  Nominal government spending stays the same but in real terms it falls and that is quite possibly contractionary.  In that case the “adjustment for inflation” makes more sense, because the boost in prices is not producing some other positive, expansionary pressure.  That scenario is fully coherent, but of course suddenly the negative real shock is the major problem and the fall in government spending is a secondary and derivative problem, albeit a potentially important one.

Going back to my initial post on European fiscal policy, there are many upset commentators but in general they are not grasping these points much less responding to them or showing some level of understanding which is deeper than my own.

I am more than willing to admit that there are deeper understandings yet than what I offer in this post, but we are not at them yet, not in this discourse at least.

I don’t wish to respond point-by-point to some of the writings in the blogosphere, but given the above, Ryan Avent also is not looking deeply enough.  Both he and Brad Plumer did not see that the posts in question clearly distinguished between spending cuts and “austerity” (Brad did issue what is arguably a correction.)  I admire both bloggers and read them regularly, but these two posts both fail; here are some comments from Veronique.  I would say there is a dominant narrative, repeated many times in not always precise language, which people find it very hard to think outside of.

Most of the time “austerity” is a misleading word and more precise concepts — readily intelligible I might add — are available.  There really are some times when we should relabel austerity as “mostly tax increases,” but many people are reluctant to do so.


Comments for this post are closed