Setting The Record Straight: Austerity Is NOT Good For The Economy

The evidence is overwhelming now.  Austerity is NOT good for the economy, for the same reason that applying leeches to cure anemia is not a good idea.  Money is the lifeblood of any economy, and cutting "deficit" spending (via tax hikes, spending cuts, or both) effectively shrinks the money supply.  And for a Monetarily Sovereign government like our own federal government, there is literally no good reason to do so at all, in good economic times or bad.

Never was, and never will be.  At least not in the post-gold standard world since August 15, 1971.

The infamous Reinhart and Rogoff (2010) outlier study that suggested that a debt/GDP ratio reaching some arbitrary level was inherently bad for the economy was roundly debunked in 2013 by a 28 year old grad student who discovered that the results were due to a coding error in the spreadsheet.  And even when Reinhart and Rogoff claimed that there still was a correlation (albeit much weaker), that was most likely due to reverse causation (i.e. due to countercylical policy responses to recessions) and residual or unmeasured confounding.

As for the Canadian experience that suggests that their austerity in the 1990s and early 2000s was somehow good for the economy has also been debunked.  The inherently harmful effects of austerity were masked by 1) an increase in the money supply, 2) a massive devaluation of the Canadian dollar, 3) a sharp cut in interest rates, 4) lag effects of previously massive deficit spending, and 5) secular global trends during that time period.  And of course, there was also the Alberta oil boom as well that continues to this day.  And they still experienced adverse effects in spite of their economic growth, particularly from the ruthless cuts to their otherwise legendary and stellar healthcare system that led to a "brain drain" and the notoriously longer "wait times" that opponents of single-payer Medicare For All disingenuously luuurve to scare ignorant Americans about.

As for Iceland in the wake of their 2008 financial crisis, they actually did more austerity than any country not named Greece.  But their austerity cuts did not begin in earnest until 2010, and the effects were essentially masked by a sharp devaluation in their currency as well as lag effects from previous deficit spending.  Thus, their massive recovery still occured in spite of budget cuts and tax hikes.

And how about the biggy:  the postwar surpluses in the late 1940 and early 1950s in the USA?  That was a deficit spending cut of a whopping 35% of GDP, yet the economy still grew like gangbusters.  But again, that growth was in spite of, not because of, their massive deficit reduction.  It was masked by massive increases in private-sector debt, lag effects of the previously massive deficits of WWII, and of course the relatively short-lived unique competitive advantage the USA had as the only major developed economy that was not devastated by the war.  And there were some fairly deep deflationary recessions during that time in 1948-1949 and 1954-1955, and before long, the federal government saw the need to run deficits once again to keep the secular economic boom going (which it did).

Thus, these exceptions really only prove the rule.  Not only is the conventional "wisdom" about austerity inaccurate, but it is in fact 100% wrong at least as far as federal finances go.  If anything, so called "deficit" spending is needed to ensure robust economic growth in the long run.  All the more reason to put an end to the Big Lie and finally decouple federal spending from taxes and Treasury securities yesterday.

In fact, since a growing economy requires a growing supply of money, and the fact that GDP = Federal Spending + Nonfederal Spending + Net Exports, one can therefore argue that a deficit/GDP ratio of at least 3% on average is needed to maintain robust economic growth of 3% per year or higher.  And to cure recessions, depressions, or secular stagnation, an even higher ratio is needed, perhaps as high as 7% or 8% even.  No wonder the EU has been persistently in the doldrums:  they actually set a 3% ceiling on their members' deficit/GDP ratios, they all have painfully high and regressive taxes such as VAT, and worse still, those nations who use the Euro are monetarily non-sovereign and cannot create their own money.

And for any country who is still contemplating fiscal austerity in spite of all this: at the very least, the growth of the money supply needs to be maintained by other means, namely the loosening of monetary policy.  Failure to do so will risk a recession or even a depression.  Note that GDP growth (or lack thereof) tends to lag the growth (or lack thereof) of the money supply by four quarters (one year) on average, sometimes even longer if there is a lot of momentum, so any apparent lack of immediate adverse effects should really not lull one into complacency.

Please note that until about 2014, the TSAP once did support austerity as well as a return to the gold standard.  We no longer do, and deeply regret ever giving any sort of credence to these outmoded ideas based on fundamental ignorance of economics.