As with so many matters, this started with reading some Dillow post or other. This is like some embarassing instance of an academic expanding 2 lines of poetry into a thesis. But Chris quite casually wrote:
And Keynesians would assent, because fiscal policy has little influence on the deficit as spending cuts reduce aggregate activity and hence tax revenue
That bit in bold is tantalizing, particularly if you are engaged in a fallacy-of-composition argument like the one you read on the post below between Andrew and I. How can fiscal policy have little influence on the deficit? Get real man.
But we saw it with Japan. And so now I want to show it with figures.
The first Scenario shows how. In this, households are determined to save 6% of GDP. The government raises 15% of private sector income as taxes. Then it determinedly spends just $150, which is what it would need in period 1 to have balance. What happens? For a Keynesian, GDP falls. This iterates, until. by around period 15, we are in balance. This is a bit like what Richard Koo found happened in Japan.
Because I am a spreadsheet UberNerd, I then mucked around to try other ideas. In Scenario 2, business lower their investment mechanically to past falls in GDP, but increase when GDP increases. This rule has faster growth once we hit the bottom, but still a net fall in GDP.
In scenario 3 I overwrite the second period with a Panic.
In scenario 4, because the government is determined to always borrow 18% and tax 15%, the spiral just keeps going down and down. This is your Great Depression scenario.
My final favourite is scenario 5. The government grows up, and allows a big deficit rather than demanding higher tax revenues in a recession. After the one year recession, the government runs a constant deficit. But GDP growth is much higher, and things go into a self-sustaining upward spiral. This one might be termed Keynesian Over Optimism.
You will notice that at the end of the scenarios, you have the household asset position, and how much debt the business and governmetn sectors have. Remember that government debt is just something someone else owns. At the end, you find the household sector has saved, and the business sector borrowed.
UPDATE: Chris Giles has a nice go at those members of the business community: “Fully knowing there is a big and unresolved debate over the effect of fiscal policy on output at the moment, the business leaders show wonderful faux ignorance of it.”