Disaster Relief Economics

This from Prof. Krugman. Please follow link to original
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Disaster Relief Economics

In a way, I may be wasting my time doing any kind of rational analysis of Eric Cantor’s demand that any disaster aid in the wake of Irene be offset by spending cuts elsewhere. Cantor is, of course, being totally hypocritical; where were the demands for offsets to the cost of invading Iraq?

Still, it may be worth talking about just how bad an idea this is in terms of basic economics — and in this case, regular economics, not fancy-schmancy macro.

Think of the government budget as involving tradeoffs similar to those an individual household makes. On one side, there are all kinds of things the government could be doing, from dropping freedom bombs to providing children with dental care; think of each of these things as involving a certain marginal benefit per additional dollar spent, with the marginal benefit declining in the total amount spent on each concern. On the other side, raising revenue has a cost, both the direct cost of the money taken from taxpayers and the possible reduction in incentives from higher tax rates.

What the government should do, in this case, is set all the marginals equal: the marginal benefit of an additional dollar spent on bombs, dental work, national parks, soup kitchens, etc, should all be equal, and this common marginal benefit should equal the marginal cost of raising an additional dollar of revenue.

Now suppose a disaster strikes. What this does is raise the marginal benefit of spending on disaster relief. The appropriate response is to move all the marginals to get them in line: spend less on everything else, and also raise more in taxes. So even there it shouldn’t be all offsetting spending cuts.

But wait: even more important, the government can borrow (or, in principle, lend, if it pays off all its debt). So it should balance its budget in present discounted value terms, not year by year. This means that the tradeoffs should include future spending and taxes as well as this year’s spending and taxes. And a natural disaster, like a war, is a temporary event; it should be met largely through higher taxes and lower spending in the future rather than right away, which is another way of saying that it should be paid for in large part by a temporary increase in the deficit.

This isn’t some novel idea, by the way — it’s the standard theory of public finance during war, going all the way back to Ricardo. And the logic of wartime finance applies equally to natural disasters.

So the bottom line is that basic, regular economics says that Cantor isn’t making sense. Are you surprised?