Sunday, February 19, 2012

Is fiscal tightening pro-growth?

The theory goes like this:

Fiscal tightening means a smaller public sector. Smaller public sector means lower tax. Lower tax will induce more private investment and create more jobs. In the end the economy will grow.

But in the experience of Greece and Portugal the fiscal tightening caused loss of job and reduced pay in public sector. Because the public sector was large this means consumers have much less money to spend. The contraction in demand pushes business to withhold investment and reduce inventory, causing a further drop in investment. Economic output drops, and new investment is not in sight because the confidence are so weak.

The conservatives think if you brave the pain, overtime the confidence will return. You should not relapse on the policy tightening and business will eventually believe the new regime is for the long term. But how much longer can people bear with the recession and despair?

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