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preet banerjee

There have been glimmers of economic hope this week with the latest EU summit and comments from both Finance Minister Jim Flaherty and Bank of Canada Governor Mark Carney that Canada and the U.S. won't fall into a recession so long as the EU can control their debt problems soon.

Nobel Laureate Joseph Stiglitz, on the other hand, does not seem so optimistic, calling austerity a "suicide pact" as the focus to reduce deficits would lead to reduced growth.

In a speech in Toronto, the Columbia University economist indicated that what upset him was that the tools exist to shorten recovery without increasing deficits – notably, the idea of the balanced budget multiplier theorem, which is a dollar-for-dollar increase in taxes and government spending. Since the increase in government spending is completely offset by an increase in tax revenue, there is no need to go further into debt to stimulate an economy.

The multiplier effect refers to the notion that government spending of $1 can translate into more than $1 of economic impact. For example, if the government pays for a bridge to be built, the money to pay for the labour will in turn be spent by the workers.

Some argue, however, that the multiplier effect might not exist if you simultaneously increase taxes as you are taking money out of the economy but simultaneously adding money back with government spending.

Mr. Stiglitz points out that if you increase taxes, consumer spending is not decreased on a dollar-for-dollar basis because while some households would pay for the tax increase by decreasing spending, others would continue to spend and pay for the tax increase by saving less. So a $1 increase in taxes, for example, would translate into less than a $1 decrease in consumer spending, whereas a $1 increase in government spending could still be very efficient.

With no increase in debt coupled with an increase in GDP, a balanced budget multiplier policy would lower the debt-to-GDP ratio, as noted earlier this year by Yale economics professor Robert Shiller. That could help restore U.S.'s credit rating as well as kickstart the economy, two factors that could give stock markets the confidence they need to pull out of the doldrums.

Sound too good to be true? We'll probably never find out how a balanced budget multiplier policy would work in practice in the current environment. With a U.S. election coming up next year, any unconventional policy that includes increasing taxes is going to have a very hard time resonating with voters en masse, no matter how much sense it may make.

Preet Banerjee, BSc, FMA, DMS, FCSI is a W Network Money Expert, and blogs at wheredoesallmymoneygo.com . You can also follow him on twitter at @PreetBanerjee