Sunday, July 17, 2011

Paul Krugman -The Wrong Perversity

Ryan Avent is upset, rightly, at the way that Obama keeps invoking the confidence fairy, in effect buying in to the doctrine of expansionary austerity — even as a growing body of research grinds what little plausibility the doctrine had into dust.

Yet perverse things do happen; it’s just that we’re focusing on the wrong perversity.

As Brad DeLong argues, there’s a very good case to be made that we’re currently living under conditions in which fiscal contraction actually worsens the long-run deficit. Why? The argument runs like this:

1. Fiscal contraction reduces output in the short run; this immediately means that part of the initial gain in terms of a lower deficit is offset by reduced revenue and higher safety-net spending. These effects are especially large when you’re in a liquidity trap, so monetary policy can’t fight the fiscal contraction.

2. Reductions in short-run output and employment take a toll on long-run growth, too: capital investment is depressed, workers lose their skills, and so on. This in turn reduces future revenues.

3. Meanwhile, with real interest rates very low — actually negative on 5-year bonds — the cost of borrowing now in terms of future debt burden is also very low.

So there is no plausible argument on behalf of the claim that fiscal contraction expands output; there is, on the other hand, a very plausible argument to the effect that fiscal contraction doesn’t even help the fiscal situation.

So guess which perversity is considered a suitable position for Serious People, and which isn’t?

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