Austerity and Keynesian Economics

I am not the best articulator of economic concepts but this is too tempting to let go. The government has decided to cut costs. MPs and ministers are being asked to fly economy and use state guest houses.

This move is an economic disaster, especially when we are yet to fully recover from the recession. The GDP of a nation can be expressed as a sum of consumption, investment, government spending and net exports:

Z = C + I + G + NX

Roughly, GDP is the total value of goods and services produced by an economy. Now, for the economy to be in equilibrium, production must equal consumption. Therefore, GDP equals aggregate demand, which equals aggregate supply.

According to Keynes, the aggregate supply drives the GDP of an economy in the long run. That is, the resources available with a nation, both natural resources and people, will eventually determine what a country can produce, and therefore, what is available for consumption. In the short run, however, it is the aggregate demand that rules. When demand goes up, supply levels will adjust upwards to meet this increase.

Now, looking at the above equation, one way to increase GDP growth is to increase consumption, which means put more money in people's hands so they can spend. This is precisely the logic behind stimulus packages. But what's the guarantee that I will spend the money? As it is, the economy is gloomy, so I might rather put it in a bank deposit. To make that option unattractive, central banks cut interest rates, so you either spend or invest your money, both of which will boost the economy as can be seen in the above equation.

Government spending is much more effective in getting economies out of recession. Every rupee spent by the government has a multiplier effect, because it creates demand, which fuels more demand and so on. Tax cuts work in a similar manner. When people have more disposable income, well, they dispose it off in some way, which boosts consumption again.

So the present government's decision to embark on an austerity drive is an economic blunder. If ministers do not stay in hotels, the hospitality industry will suffer a slump. Hotels will have to make some cut backs that will result in people losing jobs and their vendors such as catering and laundry guys losing business. When these people have less money to spend, they will cut back on festival purchases such as apparel, which is the boom season for the retail industry. So now the retail industry will get into a slump and so on.

Of course, these effects would kick in only if the government stopped "spending". I doubt if our government was ever prompt in paying for its services, and has probably accumulated several years of unpaid dues so we shouldn't worry too much.

Anyway, with solid corruption, money will still be flowing freely in the black economy that will at some point trickle into the mainstream and boost demand. I can't remember right now, but I believe at least one well-known economist actually made the point that the underground economy plays the role of a stimulus package.