Monday, November 5, 2012

Why Austerity Is Bad For Economy When Interest Rates Are Zero

Richard Koo tries again to explain what happens to an economy when private savings are high and borrowing does not absorb savings even when real interest rates are zero.  Japan cut government spending by 3% of GDP in 1997 in order to reduce its budget deficit.  This led to a 3% decline in GDP.  Tax revenues fell as well and the deficit increased by 68%.

The public does not understand why government budgets cannot be balanced when the private sector's balance sheets are over burdened with debt. They are forced to pay down their debt (savings) and someone else must be borrowing their savings.  If the government does not borrow the forced savings of the private sector, the economy will shrink.  That is not easy to explain to the public, and politicians don't help when they use budget deficits as a wedge in election campaigns.

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