Economist Brad DeLong talks about Simple Deficit Reduction Arithmetic: A Comment on Kash Mansouri, commenting on Kash Mansouri's post Some Simple Deficit Reduction Arithmetic.
Start with Kash who sets it up with an easy-to-picture $100 economy:
"Suppose we are in a country that is running a large budget deficit but, for whatever reason, decides that it needs to dramatically reduce it. Take your pick of examples, because there are plenty to choose from: Greece, the UK, the US...
"Suppose that the country -- let's call it Austerityland -- has a GDP of $100/year, and a budget deficit of $10/yr, or 10% of GDP. And suppose that the government decides it wants to get the deficit down to 5% of GDP. How can it get there?
No, the answer is not "cut spending by $5/yr."
OK, so we have a $100 GDP with $10 deficits and we want to cut that to $5. Kash explains that a $5 spending-cut means (by definition) that GDP immediately drops $5, and this (by definition) $5 drop in consumer income makes tax revenue drop as well (as well as a further drop in GDP). After some calculations (go to the post) Kash shows that a $5 cut makes deficits drop to 7.4%, not 5%, but GDP also drops quite a bit -- maybe 7% or 8%. Seriously, go see the calculations, they are not difficult.
So much of our current deficit is because of the Great Recession. Obviously we don't want to force the economy back into recession with budget cuts causing a big drop in GDP!
(Note, if this spending cut happens at a time when interest rates are high, then the rates might fall as spending cuts reduce demand, which might help spur investment, but in the US, interest rates are zero so this won't happen. The only thing that will happen is demand is reduced and the economy slows.)
Kash concludes,
"Why do people keep getting surprised that austerity doesn't work as well as hoped to reach budget deficit targets? ...
"But when basic Macro 101 both makes good theoretical sense and also fits what we actually observe, it's really time to start looking for your handy Occam's Razor."
In the UK we observe that this effect is now proven as their austerity has forced a big drop in GDP. And the same is happening with Greece as their austerity forces their economy to slow.
But Wait, It Gets Worse
After linking to this post DeLong takes the warning a bit further, pointing out that if some of the "austerity-induced output decline turns into a permanent reduction in potential output," then the "spending cuts this year lowers future annual tax collections..." which means it hurts your ability to pay off debt. Or, in other words, "that austerity today worsens the debt burden." Click through to see DeLong's calculations.
Got that? Harming the economy on purpose with spending cuts harms the economy in the future, too.
The People's Budget
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