Austerity Has Been a Big Disaster

Even more than we thought. And Krugman has big serious worries whether Europe can recover from its experiment with austerity.

It's all about the fiscal multiplier. Stimulus, you see, is measured by how much one dollar of government spending increases GDP. But in a normal economy, it doesn't. That's because the Federal Reserve has its inflation target that it's determined to hit (or at least not overshoot). Government spending, though, can flood the economy with money, raising prices in the process. So the Fed, in turn, would either raise rates to offset this spending it doesn't want, or wouldn't cut rates like it otherwise would have.

Either way, the Fed's actions would keep the economy from being any bigger with more government spending than it would be without it.

But this calculus changes when there's a recession, especially if interest rates are at zero. In that case, the Fed wouldn't want to neutralize stimulus spending. So GDP would grow at least as much as spending does - what economists call a multiplier of one - and maybe more since there could be spillover effects.

Think about it like this: spending money on roads and bridges might boost the economy more than just the money the government directly spends. That's because the newly-paid construction workers will go out and spend their money too - and so on, and so forth. Indeed, even the oh-so-orthodox International Monetary Fund estimates that the fiscal multiplier might be as high as 1.7 right now.