All Aboard the Crazy Train

Today Brazil has decided to go the way of Merkel, Abbott, and Harper inn unveiling a major austerity package which they claim is going to lift Brazil out of recession. This is fundamentally wrong and demonstrates a gross misunderstanding of how the economy works.

Here's why they are wrong in several very basic points:

1. GDP is made up of four components using the expenditure approach, Private Consumption, Investment, Government spending, and net exports. Cutting government expenditure immediately reduces GDP because it is one of the four components.
2. When people, or an organization eg government, receive income they spend a percentage of it. That expenditure then becomes somebody else's income. I receive a paycheck for $1000 and I am going to put some of it in savings, and some of it I will consume this month. I might spend $800 this month immediately on my rent, food, things I want or need which then immediately becomes the income of the person I bought the goods or services from. They then will do the same to infinity. We can mathematically calculate how much spending my increase will create with the fairly simple equation (change in income)/(1-MPC) where MPC is the percentage of income that people spend as oppose to save. If our MPC is 80% like in my fictitious example, an increase of income of $5000 from my $1000 of income.

So, if the government of Brazil wants to reduce its spending and raise its taxes it is effectively reducing the part of government expenditure that directly goes to GDP, reduces income of the people it employs which will not circulate around the economy, and this will reduce private consumption and private investment. Raising its taxes in effect will reduce the income of individuals and companies further reducing their GDP at a time when they cannot afford to.

The irony of this is that by reducing their GDP they are reducing their tax base, which will likely offset any reductions in the deficit they will get from their policies by reducing the source of their taxes. We have seen this before, and the government of Brazil should know better.

Now is the wrong time to focus on deficit spending. The first thing we need to do is get the global economy back to its appropriate growth rate, and then governments can start to reduce their debts. Actions like this are going to further reduce economic growth and prolong their current recession. It is unlikely their decision will work any differently than the other countries which have implemented this insane program.

References:

http://www.tradingeconomics.com/brazil/gdp-growth

http://www.bbc.com/news/business-34252951