An Example of Why Voodoo Econ & Education Cuts Go Hand in Hand

Added The Street Light to the blog roll. It's always worth reading & presents what some view as complex subjects in a straightforward manner. This post,which was linked by some other econ blogs is a must read:

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”. Nor is it “raise taxes by $5/yr”. And last but not least, it is also not “enact a combination of tax increases and spending cuts that total $5/yr”. To see why, let’s do just a bit of arithmetic.

If you want to talk about the deficit & especially if you want to talk about capping it as a percentage of GDP, you should understand this formula:

GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X - M).
Y = C + I + G + (X − M)

Knowing that, this should be easy to follow:

Recall that GDP is the sum of spending on final goods and services by domestic consumers, domestic businesses, and the government, along with net exports:
GDP = C + I + G + (X – M) = Y. Recall as well that GDP is, for our purposes, the same thing as income (Y).

If G is reduced by $5 in Austerityland, the first thing that happens is that GDP falls by $5. But then a bunch of secondary effects kick in, including:
C falls, since individuals in the economy have seen their income drop by $5. This makes GDP fall even further. This is called the “multiplier effect”, and it means that the total fall in GDP is likely to be substantially greater than $5. (Empirical research seems to usually show that the government spending multiplier is in the neighborhood of 1.5, implying that the net fall in GDP will be around $7 or $8.)
If interest rates are positive, they will tend to fall as demand diminishes, which could boost spending by businesses. But if interest rates are already at zero (as they are effectively are in the US), they will not fall, and we get no boost to private investment.
Tax revenues fall as income falls. If the effective marginal tax rate on income is 25% and income falls by $4, for example, then tax collections will fall by $1.
So, what is the budget deficit in Austerityland after a $5 reduction in government spending? If we assume a relatively modest multiplier of 1.5, and a tax rate of 25%, then we get:

ΔG = -$5
ΔY = -$7.5
ΔT = -$1.875

And the new deficit is now $6.875, which is 7.4% of the new level of GDP. Wait, I thought we were trying to get the deficit down to 5% of GDP? What happened?

What happened is that we’ve missed our target, by quite a bit, due to the multiplier effect and the fall in tax revenues that resulted from the shrinking economy. In fact, just a bit of simple algebra allows us to figure out that government spending in Austerityland will have to be cut by about $9 in order to reach a budget deficit target of 5% of GDP. In other words, the government will have to cut spending by almost twice as much as it initially thought it would in order to reach its deficit target.

(When that happens, by the way, GDP will fall from $100 to around $86. Yes, that’s a 14% drop in output. But hey, at least we’ve hit our deficit reduction target!)

If you've made it this far, here's the punch line:

Somehow, this simple exercise in macroeconomic math seems beyond the reach of policymakers around the world.

Many Republicans (and some Democrats) in Washington continue to believe that they can close a $1 trillion deficit by simply cutting $1 trillion in spending, and are apparently hoping to use the debt ceiling vote to do exactly that.

The Cameron government in the UK embarked on an austerity program last year to try to reduce its budget deficit, and now mysteriously keeps missing its deficit reduction targets as the UK economy shrinks.

The Greek government was forced into enacting a number of austerity measures last year, and... surprise, surprise... is now missing its 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.

When you cut education funding, you are actively working to ensure that less people can recognize when dangerous/disasterous ideas are presented as facts. If you saw a politician saying we need to balance the budget by drastically reducing the size of our economy, what would your reaction be?