Friday, March 30, 2012

What it means to cut 25 billion Euros

It looks like Rajoy’s attempt to grow a spine and tell Brussels to bug off was short lived. Now the government has commit to cut 25 billion from the budget. With all the trillions of dollars and euros that have been tossed around, it may not seem such a big number anymore to the shellshocked citizen, but the implications are huge.

Almost Euro that the government spends goes to pay for someone’s job doing something at least moderately useful. As a matter of scale, 25 billion Euros would pay for about 2 million “mileurista” jobs (~1000 euros a month).

The current number of unemployed people in Spain is 5 million. I cannot imagine how cutting the budget by this amount isn’t going to add at least another million to that number.

With the government and private sector cutting back, at the same time, while at the same time foreign investment flees the country as fast as it can…

Just to wrap up the incredible stupidity of this whole thing, cutting spending from 8% of GDP to 5% of GDP basically means that the GDP will drop by 3% just due to the drop in government spending. What makes it worse is that there is usually a “multiplier” associated with government spending of between 1.4x to 2x. For each Euro the government spends, this Euro is spent again as the people who receive it use it to buy further services.

Since the public debt level of a country is usually measured by (amount of public debt)/(GDP), effectively what is happening is this:

Currently the public debt is about 600 billion and the GDP is about 1 trillion, for a public debt of 60% of GDP. So here are the three scenarios:

  1. If Spain didn’t do the cuts (run a deficit of 8%), the debt would grow to 680 billion and for the sake of argument, say the economic didn’t shrink any more, so now we’d be at 68%.
  2. Now we do the cuts, so now the debt grows to 650 billion, but the GDP shrinks by 3% to 970 billion. So now we’re at a debt/GDP ratio of 67%.
  3. However, if we do the cuts and assume a multiplier of 2 on government spending, cutting 3% GDP of spending means a real cut to the GDP of 6%, which brings the GDP to 69%, which is worse than doing nothing.

If I had to place bets, my money would be on #3.

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