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?

Economic Blogs

Quick note to mention that I added Bonddad's blog and Eschaton to the blogroll. Bonddad does detailed anaysis of economic data. Eschaton is a liberal blog with a economic focus.

Eschaton was the blog that was calling out the pending financial crisis as early as late 2005. When I started seeing news stories about events that Atrios (the editor of Eschaton) had been predicting, I moved my 401(k) into the lowest risk options available and was lucky enough to avoid the losses that my colleagues suffered. Atrios is pretty concerned about the commercial real estate market right now.

For some reason blogspot isn't recognizing updates to Eschaton, so it won't rise up the blogroll list based on latest update. It's updated several times daily.

Buffet on the Economy

Warren Buffet quoted in Reuters:

Buffett, a supporter of President Barack Obama during last year's election campaign, said a second economic stimulus package might be needed. The Obama administration says it does not see a need for a second stimulus yet.

"I think a second one may well be called for. It is not a panacea. A stimulus is the right thing. You hope it doesn't get watered down," he said.

He likened the first $787 billion stimulus package passed by Congress to "half a tablet of Viagra and then having also a bunch of candy mixed in --- it doesn't have really quite the wallop."

...

"We're going to come out of this better than ever, the best days of America lie ahead but not next week or next month," he said.

Recovery.gov On Line

As promised, the tracking site for the The American Recovery and Reinvestment Act is up and running.

...Better...

The President sharpens his tone today:

In the last few days, we've seen proposals arise from some in Congress that you may not have read but you'd be very familiar with because you've been hearing them for the last 10 years, maybe longer. They're rooted in the idea that tax cuts alone can solve all our problems; that government doesn't have a role to play; that half-measures and tinkering are somehow enough; that we can afford to ignore our most fundamental economic challenges -- the crushing cost of health care, the inadequate state of so many of our schools, our dangerous dependence on foreign oil.

So let me be clear: Those ideas have been tested, and they have failed. They've taken us from surpluses to an annual deficit of over a trillion dollars, and they've brought our economy to a halt. And that's precisely what the election we just had was all about. The American people have rendered their judgment. And now is the time to move forward, not back.

Video:

Visit msnbc.com for Breaking News, World News, and News about the Economy

The President writes Op-Ed in The Washington Post

A strong reminder of the urgency of passing economic stimulus.

In recent days, there have been misguided criticisms of this plan that echo the failed theories that helped lead us into this crisis -- the notion that tax cuts alone will solve all our problems; that we can meet our enormous tests with half-steps and piecemeal measures; that we can ignore fundamental challenges such as energy independence and the high cost of health care and still expect our economy and our country to thrive.

I reject these theories, and so did the American people when they went to the polls in November and voted resoundingly for change. They know that we have tried it those ways for too long. And because we have, our health-care costs still rise faster than inflation. Our dependence on foreign oil still threatens our economy and our security. Our children still study in schools that put them at a disadvantage. We've seen the tragic consequences when our bridges crumble and our levees fail.

Every day, our economy gets sicker -- and the time for a remedy that puts Americans back to work, jump-starts our economy and invests in lasting growth is now.

Hopefully, he'll follow up with a prime time TV address to the nation.

UPDATE: Looks like the TV address is Monday at 7pm.