Suppose we are in a country that is running a large budget deficit but, for whatever reason, decides that it needs to dramatically reduce it. Take your pick of examples, because there are plenty to choose from: Greece, the UK, the US...
Suppose that the country – let’s call it Austerityland – has a GDP of $100/year, and a budget deficit of $10/yr, or 10% of GDP. And suppose that the government decides it wants to get the deficit down to 5% of GDP. How can it get there?
No, the answer is not “cut spending by $5/yr”. Nor is it “raise taxes by $5/yr”. And last but not least, it is also not “enact a combination of tax increases and spending cuts that total $5/yr”. To see why, let’s do just a bit of arithmetic...
...[With a $5 cut in spending] the new deficit is now $6.875, which is 7.4% of the new level of GDP. Wait, I thought we were trying to get the deficit down to 5% of GDP? What happened?
What happened is that we’ve missed our target, by quite a bit, due to the multiplier effect and the fall in tax revenues that resulted from the shrinking economy. In fact, just a bit of simple algebra allows us to figure out that government spending in Austerityland will have to be cut by about $9 in order to reach a budget deficit target of 5% of GDP. In other words, the government will have to cut spending by almost twice as much as it initially thought it would in order to reach its deficit target.
(When that happens, by the way, GDP will fall from $100 to around $86. Yes, that’s a 14% drop in output. But hey, at least we’ve hit our deficit reduction target!)
And here's today's news out of Greece:
Greece to miss budget deficit targets in 2011 and 2012
Greece has said its budget deficit will be cut in 2011 and 2012 but will still miss targets set by the EU and IMF. The 2011 deficit is projected to be 8.5% of GDP, down from 10.5% in 2010 but short of the 7.6% target.
The government, which on Sunday adopted its 2012 draft budget, blamed the shortfall on deepening recession... It blamed an economic contraction this year of 5.5% - rather than May's 3.8% estimate - for the failure to meet deficit targets.