The Balanced Budget Multiplier Effect and Really Bad News For The Global Economy

I attended a few presentations today at The Toronto Forum for Global Cities presented by The International Economic Forum of The Americas. What a mouthful.

One of the speakers today was Nobel Laureate Joseph Stiglitz who was very engaging, although fairly downbeat about Europe, the US and pretty much everything.

He mentioned that a possible way to fix the US’s economic problems was to take advantage of something known as the Balanced Budget Multiplier. Since they are running up against massive deficits and debt, spending stimulus alone is hard to employ. Instead, the government could increase taxes and spending equally.

This would seem paradoxical but a $1 increase in tax would not necessarily result in a $1 decrease in spending by all consumers. Low income earners may pay that $1 in extra tax by a full $1 decrease in spending, but higher income earners would pay for some of that $1 extra tax with a combination of reduced spending and reduced saving. Very high income earners would pay for all of that $1 in extra tax with a $1 reduction in savings with no change on their spending. And since higher income earners would be paying more of the extra tax, the overall decrease in spending is a fraction of the increase in tax.

On the flip side, the extra $1 in spending by the government could go into EI benefits (as an example) where most of the money collected by claimants is spent right away. Therefore the economic benefit of government spending here is realized quickly.

So essentially, while you have a balanced budget modification of equal dollars in extra tax revenue being spent to stimulate the economy, the decrease in consumption by the extra tax is less than the increase in consumption by the government’s extra spending.

The bad news, unfortunately, is that this would never make it through congress. Further, he commented that austerity measures (increased taxes and decreased spending) were essentially economic suicide pacts. The decrease in stimulus would have negative GDP impacts, and using Greece as an example you can see that it would be possible that GDP decreases more than debt does, so the debt to GDP ratio may actually get worse with austerity measures.

He certainly didn’t mince words.

Preet Banerjee
Preet Banerjee an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 3 comments
  • Danial

    Preet, thank you for making it easy to understand :)

    • Preet

      @Danial – thanks for the kind words! :)

  • dj

    All 3 levels of Gov. spend more then they takin taxes…fix this cash flow problem…oh wait they will lose Gov. job an gold plated pension…not going to happen…inflation is not going to work because we are at the wrong ponit in the cycle…Econ 101 is a Bit$h