Deficits or Austerity?

If you're not quite clear on the theoretical basis for deficit spending in recessions, this is a must read (excerpt):

Fiscal austerity – the newest fallacy of composition

Prior to the 1930s, there was no separate study called macroeconomics. The mainstream theory – which dominates still today – considered macroeconomics to be an aggregation of the individual. So the representative firm and household were just made bigger but the underlying behavioural principles that were brought to bear on the analysis were those that applied at the individual level.

So the economy is seen as being just like a household or single firm. Accordingly, changes in behaviour or circumstances that might benefit the individual or the firm are automatically claimed to be of benefit to the economy as a whole.

The general reasoning failure that occurs when one tries to apply logic that might operate at a micro level to the macro level is called the fallacy of composition. In fact, it is what led to the establishment of macroeconomics as a separate discipline. As indicated, prior to the Great Depression, macroeconomics was thought of as an aggregation of microeconomics. The neo-classical economists (who are the precursors to the modern neo-liberals) didn’t understand the fallacy of composition trap and advocated spending cuts and wage cuts at the height of the Depression.

The question here is whether the same conditions apply here in Malaysia – the examples used in the post best fit a "closed" economy with no external sector. In our case, we're facing a shortfall in external demand, not domestic demand, where consumers in developed countries are trying to save more. But in that case, what we should be arguing about is not whether the government should intervene to maintain aggregate demand, but what form that intervention should take (note: one more reason why BNM should not raise the OPR today).

I’m in two minds about the rather vague reports in the papers of “major projects”, as the problem with that is the empirical support for high multiplier effects of spending on construction is in developed economies with relatively small external sectors. Given the high import content of our construction materials, I’m not sure that import leakage might not completely offset the long term gains from infrastructure investment.

There hasn’t been much research done on fiscal multipliers in developing countries, so while the general theoretical basis is there, the empirical evidence in support is not. We are in some ways flying blind here – hopefully there isn't a mountain in the way.