Free Exchange in The Economist debated this topic and went into detail concerning the Fiscal Multiplier. It refers to the change in GDP that is due to a change in government fiscal policy – taxes and spending. They use the following examples
Multiplier = 1.5 Government Spending down $1 = overall spending down = $1.5
Multiplier = 0.5 Government Spending down $1 = overall spending down = $0.5
Therefore the value of the multiplier is the crucial variable and a value that is greater than the level of GDP you maybe able to close the deficit but this results in a higher debt to GDP ratio than it started with. Estimates of the fiscal multiplier have been approximately 1% or below and the IMF have suggested that if you cut deficits by 1% of GDP it will have an impact of 0.5% of GDP – multiplier value of 0.5. What has been suggested is that:
Spending cuts may “crowd in” private-sector activity: if governments are using up scarce capital and labour then austerity creates room for private firms to expand. In open economies, austerity’s bite can be passed on to other countries through reduced imports. Most important of all, monetary policy can act as a counterweight to fiscal policy. Spending cuts that threaten to drag growth below a desired level should prompt monetary easing, limiting the multiplier.
However timing is everything and austerity measures now are not conducive to favourable outcomes for the following reasons:
1. With many economies implementing the same measures the impact can’t be deflected onto others.
2. Austerity measures normally might free up resources for private use but that mattered far less when unemployment and saving were high.
3. With interest rates at near-zero levels there was little scope for any additional monetary stimulus to offset the fiscal tightening. Monetary policy has run out of ammunition.