Austerity

For other uses, see Austerity (disambiguation).

For the current opposition to present-day austerity measures, see Anti-austerity protests.

In economics, austerity refers to a policy of deficit-cutting by lowering spending via a reduction in the amount of benefits and public services provided. Austerity policies are often used by governments to try to reduce their deficit spending and are sometimes coupled with increases in taxes to demonstrate long-term fiscal solvency to creditors.

Supporters of austerity predict that under expansionary fiscal contraction (EFC), a major reduction in government spending can change future expectations about taxes and government spending, encouraging private consumption and resulting in overall economic expansion.

Critics argue that, in periods of recession and high unemployment, austerity policies are counter-productive, because: a) reduced government spending can increase unemployment, which increases safety net spending while reducing tax revenue; b) reduced government spending reduces GDP, which means the debt to GDP ratio examined by creditors and rating agencies does not improve; and c) short-term government spending financed by deficits supports economic growth when consumers and businesses are unwilling or unable to do so.

Justifications

Austerity measures are typically taken if there is a threat that a government cannot honor its debt liabilities. Such a situation may arise if a government has borrowed in foreign currencies that they have no right to issue or they have been legally forbidden from issuing their own currency. In such a situation, banks and investors may lose trust in a government's ability and/or willingness to pay and either refuse to roll over existing debts or demand extremely high interest rates. In such situations, inter-governmental institutions such as the International Monetary Fund (IMF) may demand austerity measures in exchange for functioning as a lender of last resort. When the IMF requires such a policy, the terms are known as 'IMF conditionalities'.

In some cases, governments became highly indebted after assuming private debts following banking crises. For example, this occurred after Ireland assumed the debts of its private banking sector during the European sovereign debt crisis.

Typical effects

Development projects, welfare, and other social spending are common programs that are targeted for cuts: Taxes, port and airport fees, train and bus fares are common sources of increased user fees. Retirement ages may be raised and government pensions reduced.

In many cases, austerity measures have been associated with protest movements claiming significant decline in standard of living. A representative example is the nation of Greece. The financial crisis—particularly the austerity package put forth by the EU and the IMF— was met with great anger by the Greek public, leading to riots and social unrest. On 27 June 2011, trade union organizations commenced a forty-eight hour labor strike in advance of a parliamentary vote on the austerity package, the first such strike since 1974. Massive demonstrations were organized throughout Greece, intended to pressure parliament members into voting against the package. The second set of austerity measures was approved on 29 June 2011, with 155 out of 300 members of parliament voting in favor. However, one United Nations official warned that the second package of austerity measures in Greece could pose a violation of human rights.

Theoretical considerations

Keynesian viewpoint

John Maynard Keynes said in 1937: “The boom, not the slump, is the right time for austerity at the Treasury.” Contemporary Keynesian economists argue that budget deficits are appropriate when an economy is in recession, to reduce unemployment and help spur GDP growth.

Economist Paul Krugman explained that a government is not like a household. Across an economy, one person's spending is another person's income. If everyone is trying to reduce their spending, the economy can be trapped in what economists call the paradox of thrift, worsening the recession as GDP falls. If the private sector is unable or unwilling to consume at a level that increases GDP and employment sufficiently, he argued the government should be spending more.

Multiplier effects

Different revenue (tax) and spending choices of equal magnitude have different economic effects. For example, the U.S. Congressional Budget Office estimated that the payroll tax (levied on all workers earning a wage) has a higher multiplier (impact on GDP) than the income tax (which is levied primarily on wealthier workers). In other words, raising the payroll tax by $1 as part of an austerity strategy would slow the economy more than raising the income tax by $1, resulting in less net deficit reduction. In theory, it would be stimulative to the economy and reduce the deficit if the payroll tax were lowered and the income tax raised in equal amounts.

Other views

Old-Keynesians, such as Alvin Hansen argued that government deficits provide the private sector both with new money for saving (the deficit) and a means to save (government interest-bearing bonds), increasing private sector wealth, and this wealth effect would reduce the need to save from current income. In their view government debt enabled the private sector to continue consuming. It was therefore not a burden, at least when held domestically, but a necessity. This approach has interesting parallels with Richard Koo's recent concept of balance-sheet recession.

Contemporary mainstream economists model macroeconomic policy in a dynamic stochastic general equilibrium (DSGE) framework, where fiscal policy is discussed within an optimal taxation framework that assumes a representative agent is optimizing over a long-term horizon. The reasoning behind such models is that the effect of any government deficit is mitigated by compensatory changes in the representative agent's spending decisions. This occurs because the agent will be responsible for paying off that deficit in the future. Thus, from a modern mainstream macroeconomist's point of view, reducing government deficits allows the private sector to consume more and support the economy. This viewpoint stems from their belief in the existence of a general economic equilibrium, which predicts that economic fluctuations revert back toward a "normal" state of affairs automatically. For this reason econometric models that are used in economic forecasting are calibrated to show convergence to full resource utilization and employment despite government's fiscal tightening.

According to modern monetary theory austerity measures by a national government are usually counterproductive because neither taxation nor bond issuance acts as a funding mechanism for the government. Instead all spending is done by crediting bank accounts, so national governments cannot run out of money unless they have fixed exchange rate to either foreign currency or gold or are part of a larger currency area like the eurozone where they do not have the right to issue money.

Austrian School economists argue that austerity measures do not necessarily increase or decrease economic growth. Rather, they argue that all attempts by central governments to prop up asset prices, bail out insolvent banks, or "stimulate" the economy with deficit spending make stable growth less likely.

Empirical considerations

Public Debt to GDP Ratio for Selected European Countries - 2008 to 2011. Source Data: Eurostat

A typical goal of austerity is to reduce the annual budget deficit without sacrificing growth. Over time, this may reduce the overall debt burden, often measured as the ratio of public debt to GDP. During the European sovereign-debt crisis, many countries embarked on austerity programs, reducing their budget deficits relative to GDP from 2010 to 2011. For example, according to the CIA World Factbook Greece improved its budget deficit from 10.4% GDP in 2010 to 9.6% in 2011. Iceland, Italy, Ireland, Portugal, France and Spain also improved their budget deficits from 2010 to 2011 relative to GDP.

However, with the exception of Germany, each of these countries had public debt to GDP ratios that increased (worsened) from 2010 to 2011, as indicated in the chart at right. Greece's public debt to GDP ratio increased from 143% in 2010 to 165% in 2011. This indicates that despite improving budget deficits, GDP growth was not sufficient to support a decline (improvement) in the debt to GDP ratio for these countries during this period. Eurostat reported that the debt to GDP ratio for the 17 Euro area countries together was 70.1% in 2008, 79.9% in 2009, 85.3% in 2010, and 87.2% in 2011.

Unemployment is another variable that might be considered in evaluating austerity measures. According to the CIA World Factbook, from 2010 to 2011, the unemployment rates in Spain, Greece, Ireland, Portugal and the UK increased. France and Italy had no significant changes, while in Germany and Iceland the unemployment rate declined.

Discretionary spending, mandatory spending, and revenue increases over nine-year intervals

Another historical example of austerity was in the United States, which balanced its budget from 1998 to 2001. The basic strategy was to limit the rate of growth in defense and non-defense discretionary spending (which funds the major cabinet departments and agencies) during most of the 1990s, while growing revenues along with the economy. Comparing 1990 vs. 1999, defense and non-defense discretionary spending grew by a total of 14%, while revenues grew 77%. Public debt to GDP declined from 42.1% in 1990 to 39.4% by 1999, although it rose during the interim slightly. In contrast, from 2000–2009, discretionary spending grew by a total of 101% while revenues grew only 4%. Public debt to GDP increased from 34.7% in 2000 to 53.5% in 2009. Revenue grew nearly 25% when comparing 2000 to the pre-crisis peak in 2007, still considerably less than the prior decade.

Controversy

Main article: Anti-austerity protests

Austerity programs can be controversial. In the Overseas Development Institute briefing paper "The IMF and the Third World" the ODI addresses five major complaints against the IMF's austerity 'conditionalities'. These complaints include these measures being "anti-developmental", "self-defeating", and "they tend to have an adverse impact on the poorest segments of the population". In many situations, austerity programs are implemented by countries that were previously under dictatorial regimes, leading to criticism that the citizens are forced to repay the debts of their oppressors.

Economist Richard D. Wolff has stated that instead of cutting government programs and raising taxes, austerity should be attained by collecting (taxes) from non-profit multinational corporations, churches, and private tax-exempt institutions such as universities, which currently pay no taxes at all.

In 2009, 2010, and 2011, workers and students in Greece and other European countries demonstrated against cuts to pensions, public services and education spending as a result of government austerity measures. Following the announcement of plans to introduce austerity measures in Greece, massive demonstrations were witnessed throughout the country, aimed at pressing parliamentarians to vote against the austerity package. In Athens alone 19 arrests were made while 46 civilians and 38 policemen had been injured by 29 June 2011. The third round austerity has been approved by the Greece parliament on 12 February 2012 and has met strong opposition especially in the cities of Athens and Thessaloniki where police clashed with demonstrators.

Opponents argue that austerity measures depress economic growth, and ultimately cause reduced tax revenues that outweigh the benefits of reduced public spending. This is especially the case when austerity measures affect the private sector and do not merely correct unreasonable expenditures on the public sector workforce. The case of Greece significantly corroborates these views. Moreover, in countries with already anemic economic growth, austerity can engender deflation which inflates existing debt. Such austerity packages can also cause the country to fall into a liquidity trap, causing credit markets to freeze up and unemployment to increase. Opponents point to cases in Ireland and Spain in which austerity measures instituted in response to financial crises in 2009 proved ineffective in combating public debt, and placing those countries at risk of defaulting in late 2010.

Austerity sequence

Further information: Household debt

Several economists have argued that an appropriate strategy when an economy is faced with unusually high private debt levels is to exchange private debts for public debts initially, then cut government debt via an austerity strategy once the economy recovers. Applying an austerity strategy to a struggling economy can be counter-productive according to Keynesian theory described above.

For example, the private sector may become highly indebted, such as when a housing bubble bursts. Housing prices fall while the mortgage obligations remain fixed, leading to "underwater" homeowners unable to consume at sufficient levels to drive economic growth. A banking crisis can result, as defaulting homeowners result in banks unable to lend or stay in business, which slows the economy and worsens unemployment. These effects can become self-reinforcing, creating a downward economic spiral. This spiral is at the core of the subprime mortgage crisis in the U.S. and the European sovereign debt crisis.

Economist Amir Sufi at the University of Chicago argued in July 2011 that a high level of household debt was holding back the U.S. economy. Households focused on paying down private debt are not able to consume at historical levels. He advocated mortgage write-downs and other debt-related solutions to re-invigorate the economy when household debt levels are exceptionally high.

Economists Joseph Stiglitz and Mark Zandi both advocated significant mortgage refinancing or write-downs during August 2012. This could be financed by the government taking on additional debt in the short-run as a form of stimulus. The government would borrow at a very low interest rate and create an entity to purchase mortgages, receiving a higher interest rate from mortgages it refinances. Losses due to mortgage principal write-downs would be shared between the government and financial institutions, with the government losses offset by the interest rate differential.

The International Monetary Fund (IMF) reported in April 2012: "Household debt soared in the years leading up to the Great Recession. In advanced economies, during the five years preceding 2007, the ratio of household debt to income rose by an average of 39 percentage points, to 138 percent. In Denmark, Iceland, Ireland, the Netherlands, and Norway, debt peaked at more than 200 percent of household income. A surge in household debt to historic highs also occurred in emerging economies such as Estonia, Hungary, Latvia, and Lithuania. The concurrent boom in both house prices and the stock market meant that household debt relative to assets held broadly stable, which masked households’ growing exposure to a sharp fall in asset prices. When house prices declined, ushering in the global financial crisis, many households saw their wealth shrink relative to their debt, and, with less income and more unemployment, found it harder to meet mortgage payments. By the end of 2011, real house prices had fallen from their peak by about 41% in Ireland, 29% in Iceland, 23% in Spain and the United States, and 21% in Denmark. Household defaults, underwater mortgages (where the loan balance exceeds the house value), foreclosures, and fire sales are now endemic to a number of economies. Household deleveraging by paying off debts or defaulting on them has begun in some countries. It has been most pronounced in the United States, where about two-thirds of the debt reduction reflects defaults." These countries might also benefit from household debt reduction policies involving exchanging private debt for public debt.

The "Age of Austerity"

The term “Age of austerity” was popularized by British Conservative leader David Cameron in his keynote speech to the Conservative party forum in Cheltenham on 26 April 2009, when he committed to put an end to what he called years of excessive government spending.

Word of the year

Merriam-Webster's Dictionary named the word "austerity" as its "Word of the Year" for 2010 because of the number of web searches this word generated that year. According to the president and publisher of the dictionary, "austerity had more than 250,000 searches on the dictionary's free online [website] tool" and the spike in searches "came with more coverage of the debt crisis".

Examples of austerity

• Argentina, 1952,2012
• Cuba, 1991
• Czech Republic, 2010
• Germany, 2011
• Greece, 2010–2012
• Ireland, 2010
• Israel, 1949–1959
• Italy, 2010
• Japan, 2010
• Latvia, 2009
• Mexico, 1985
• Netherlands, 1982–1990, 2003–2006, 2011
• Canada, 1994
• Nicaragua, 1997
• Palestinian Authority, 2006
• Romania, 2010
• Portugal, 2010–2011
• Puerto Rico, 2009–2013
• Spain, 1979, 2010
• United Kingdom, during and after the two World Wars, 2011–2014
• United States, 1921, 1946
• Naples, Italy 2012

See also

• Functional finance
• Paradox of thrift
• Planned shrinkage

External links

• The Austerity Zone: Life in the New Europe – videos by The New York Times
• Video: Richard Koo debates Kenneth Rogoff about the need for austerity, Institute for New Economic Thinking inaugural conference, 22 April 2010
• Socialist Studies Special Edition on Austerity (2011)