Tuesday, June 18, 2013

Where The "Confidence Fairy" Comes From, And How It Justified Austerity Progams

This link, to a brilliant economic lecture by Mark Blyth, contains a segment which explains how spending cuts by government are supposed to stimulate economic growth.  According to rational expectations theory individuals will perceive that a reduction in government spending will lead to lower taxes in the future.  Therefore, individuals will conclude that they can spend some of their future tax savings today.  This decision, based upon rational expectations about future taxes,  is supposed give individuals the confidence to spend more today.  Expectations about the future, apparently trump one's personal circumstances today.  The "confidence fairy" is based upon the faulty assumptions in rational expectations theory.  It became one of the chief economic arguments used to support austerity programs.

Rational expectations theory was also used by top economists, like Robert Barro from Harvard, who made a similar argument against the use of government spending to stimulate the economy.  Barro argued that individuals would realize that taxes would have to increase in the future to pay for the increase in government spending.  Therefore, they would save more of their income in order to fund future taxes.  Increased savings today, by rational individuals who can predict future tax increases, will reduce spending today.  Increased government spending, therefore, cannot stimulate the economy.

According to rational expectations theory, the best thing that governments can do to stimulate economic growth is to cut spending and cut taxes.  That is austerity theory in a nutshell.  It will produce the "confidence fairy" and eliminate the lack of confidence that individuals have about the future.

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