Can the inflationary erosion of G lead to austerity?

In response to my earlier post, Kevin Drum attempts to identify the problem of austerity by graphing real, per capita government spending in the United States.  But choosing real government spending can be a misleading way of measuring the contribution of fiscal policy to aggregate demand.  (The per capita decision also can be partially disputed on the grounds that government is producing some national public goods.)

Real cuts in government spending, when due to inflationary erosion of G, will not in general be identifying a problem of aggregate demand.  And aggregate demand is what we are considering here, not potential problems with supply provision (e.g., how many children are getting vaccines?), which are well identified by looking at the real variables.

Take two societies, each with flat nominal government spending.  One society has price inflation of five percent, the other ten percent.  In the latter case real government spending is falling by ten percent, a bigger decline than for the first society.  But can we properly conclude that the second society will be having a bigger problem of aggregate demand?  No, the price level is going up ten percent!  The erosion itself is being caused by higher nominal demand.

If real government spending is declining because of price inflation, that fact, taken alone, is unlikely to be associated with an aggregate demand problem.  After all, we are not talking about inflation induced by oil price hikes.  We are talking about inflation pushed along by…demand.

One of the trickiest problems in economics is knowing when the “real” variable can be a misleading metric.

More generally, consider this Marcus Nunes post: “For the whole period depicted in the chart the correlation between real output growth and real G growth is significantly NEGATIVE!”  That is of course in part the result of an identification problem (fiscal policy often becomes more active in bad times), but look at the last few years of the chart only.  What you will see is a murky story that, no matter what machinations and Ptomelaic epicycles you may get from some of the more polemic Keynesians, is not well illuminated by Keynesian economics in the traditional sense.

Here are some other chart comparisons.

It is fine to say it is murky.  It is murky.  Murky, murky, murky.  But from that we should not conclude that fiscal policy is extremely effective, as it probably is not in most cases.  That is part of what murky implies.

Here is Scott Sumner with questions for Keynesians, all of them on the mark, read the whole thing.

NB: If you read this post as arguing “there was no aggregate demand problem in years ????”, go to community college!

Or if you read this post as saying “Cowen thinks nominal government spending is the correct measure of austerity…and that is wrong…”, well, go back to high school!  There is no “correct measure,” it depends on the question you are asking and even then more than one measure may be relevant.


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