When governments cut spending, they cut spending on primarily on services, not goods (except perhaps spending on guns and fighter jets). This means that the direct effects of austerity fall squarely on the shoulders of the domestic labour force (except, perhaps, some foreign defence industry workers). The fall in demand causes wages to be pushed down and unemployment to rise. This seems to be a fair description of the consequences of what is happening as fiscal stimulus is withdrawn in many advanced economies – but is fiscal austerity the right thing to do?
So, aside from restoring government spending to its original level, what is the government to do to get the economy out of this mess? If you have a central bank that has an inflation target, the frontline response is for the central bank to inject enough money into the system to avoid deflation and try to keep services prices from falling. Given current circumstances, suppose that the central bank does this through a quantitative easing program – directly injecting cash into the economy.
There are different theories about what will happen too that money, but let’s simply assume that people just go out and spend it. In order to avoid the deflationary outcome, the central bank will keep on increasing the money supply until spending rises enough that the excess capacity in the economy (the horizontal distance AB) is eliminated. Unlike the government, people generally spend any extra cash that they have on both goods and services, and therefore consumption demand tends to increase along the ray OB. Thus the economy is not going to return to its original consumption equilibrium where it consumes what it produces at A. Exactly where it ends up will (in the near term) depend on what happens to the exchange rate.
Suppose that the exchange rate is fixed. This means that the price of the traded good is not changing, and so long as wages aren’t falling firms have no incentive to change the amount of tradeable goods that they produce, but as demand rises, demand for both goods and services increase. The increase in demand for goods is accommodated for by importing the extra, while the increase in demand for services is met by increased domestic production. Firms start to re-hire the unemployed to produce more services. So the production side of the economy reverses tack and heads back to point A as consumption moves along the ray 0B. With a fixed exchange rate and a monetary injection large enough to eliminate the unemployment the consumption bundle ends up at point C right above point A. The economy is consuming the same amount of services, but importing the extra tradeable goods (measured by the distance CA).
In this fixed exchange rate case, these extra imports are being paid for by the injection of cash and this equilibrium can last as long as someone out there in the rest of the world is willing to accept that extra currency for those imports.
Note that this simple model has an interesting prediction. A country that has a fixed exchange rate that engages in austerity will need a large monetary injection to offset the unemployment created by that austerity. Whatsmore, that injection will translate into a trade deficit. The opposite is true of an increase in spending – a country that increases government spending could benefit from a monetary contraction to avoid overheating, but this would result in a trade surplus.
So let’s apply the model to the world today. If this was the euro zone, where the German trade balance is in surplus, and Spain, Portugal, Greece and Ireland have troublesome deficits, then shouldn’t Germany be the one taking fiscal austerity and the periphery countries being the ones undertaking fiscal expansion, with the ECB channelling funds from the periphery to Germany. But this is the opposite of what is happening. Why? Because countries like Spain and Portugal are perceived by markets as having governments that are fiscally weak, while Germany is perceived as fiscally strong. On the other hand, banks in the periphery are generally weak and are making use of ECB funding while German banks are not. As a consequence, the current “solutions” to the euro area crisis seem to be set to perpetuate the same euro imbalances that created the crisis in the first place.
The same is true in the United States, whose exchange rate is largely fixed against the yuan. This explains why the US trade deficit is not contracting as it should.
On the other hand, with its fully flexible exchange rate, the UK might be going about things the right way. Going back to the Salter diagram, austerity combined with loose monetary policy will result in a depreciated exchange rate and the economy consuming what it produces at point D.