Krugman spells out the Paradox of Thrift: when the interest rate goes to zero — like the past five years — cuts in spending reduce the incentive to invest, which is contrary to the normal regime:
For those who don’t know or don’t get the paradox of thrift, it’s actually very simple: if people (or the government) cut their spending, and the Fed can’t offset this move by cutting interest rates, the economy will contract — and the economy’s contraction will reduce the incentive to invest, so that investment actually falls.
I know that many economists just refuse to accept this proposition, which seems absurd to them. But what, exactly, is their alternative? If you believe that a cut in spending under current conditions — it doesn’t matter whether it’s public or private spending — leads to more rather than less investment, what is the mechanism? How does my spending cut give businesses a reason to spend more rather than less (other than via the confidence fairy)? Remember, interest rates can’t fall — the zero lower bound isn’t a theory, it’s a fact, and it’s a fact that we’ve been facing for five years now.
What’s more, the turn to austerity that began in 2010 gives us an opportunity to observe the paradox in action. Take the estimates of fiscal contraction 2009-13 from the IMF Fiscal Monitor in fall 2012 (Figure 13), and compare this with changes in real fixed investment over the same period (from Eurostat). It looks like this:
That’s Greece in the lower right corner, of course — but even without Greece there’s a clear negative correlation between government austerity and investment. Yes, you can try to explain away the results with endogeneity, but it’s a strain. This is prima facie evidence of crowding-out in reverse, aka the paradox of thrift.
The thing is, this topsy-turvy world we’re living in, where virtue is vice and prudence is folly, may violate many intuitions — but it’s a world thoroughly mapped out by textbook macroeconomics in advance, and it’s a world we’ve been living in for five years. It is, in fact, the new normal. What will it take for economists, let alone policymakers, to accept reality?