Austerity
In economic policy, austerity is a set of political-economic policies that aim to reduce government budget deficits through spending cuts, tax increases, or a combination of both. There are three primary types of austerity measures: higher taxes to fund spending, raising taxes while cutting spending, and lower taxes and lower government spending. Austerity measures are often used by governments that find it difficult to borrow or meet their existing obligations to pay back loans. The measures are meant to reduce the budget deficit by bringing government revenues closer to expenditures. Proponents of these measures state that this reduces the amount of borrowing required and may also demonstrate a government's fiscal discipline to creditors and credit rating agencies and make borrowing easier and cheaper as a result.
In most macroeconomic models, austerity policies which reduce government spending lead to increased unemployment in the short term. These reductions in employment usually occur directly in the public sector and indirectly in the private sector. Where austerity policies are enacted using tax increases, these can reduce consumption by cutting household disposable income. Reduced government spending can reduce gross domestic product growth in the short term as government expenditure is itself a component of GDP. In the longer term, reduced government spending can reduce GDP growth if, for example, cuts to education spending leave a country's workforce less able to do high-skilled jobs or if cuts to infrastructure investment impose greater costs on business than they saved through lower taxes. In both cases, if reduced government spending leads to reduced GDP growth, austerity may lead to a higher debt-to-GDP ratio than the alternative of the government running a higher budget deficit. In the aftermath of the Great Recession, austerity measures in many European countries were followed by rising unemployment and slower GDP growth. The result was increased debt-to-GDP ratios despite reductions in budget deficits.
Theoretically in some cases, particularly when the output gap is low, austerity can have the opposite effect and stimulate economic growth. For example, when an economy is operating at or near capacity, higher short-term deficit spending can cause interest rates to rise, resulting in a reduction in private investment, which in turn reduces economic growth. Where there is excess capacity, the stimulus can result in an increase in employment and output. Alberto Alesina, Carlo Favero, and Francesco Giavazzi argue that austerity can be expansionary in situations where government reduction in spending is offset by greater increases in aggregate demand.
History
The origin of modern austerity measures is mostly undocumented among academics. During the United States occupation of Haiti that began in 1915, the United States utilized austerity policies where American corporations received a low tax rate while Haitians saw their taxes increase, with a forced labor system creating a "corporate paradise" in occupied Haiti. Another historical example of contemporary austerity is Fascist Italy during a liberal period of the economy from 1922 to 1925. The fascist government utilized austerity policies to prevent the democratization of Italy following World War I, with Luigi Einaudi, Maffeo Pantaleoni, Umberto Ricci and Alberto de' Stefani leading this movement. Austerity measures used by the Weimar Republic of Germany were unpopular and contributed towards the increased support for the Nazi Party in the 1930s.Justifications
Austerity measures are typically pursued if there is a threat that a government cannot honour its debt obligations. This may occur when a government has borrowed in currencies that it has no right to issue, for example a South American country that borrows in US dollars. It may also occur if a country uses the currency of an independent central bank that is legally restricted from buying government debt, for example in the Eurozone.In such a situation, banks and investors may lose confidence in a government's ability or willingness to pay, and either refuse to roll over existing debts, or demand extremely high interest rates. International financial institutions such as the International Monetary Fund may demand austerity measures as part of Structural Adjustment Programmes when acting as lender of last resort.
Austerity policies may also appeal to the wealthier class of creditors, who prefer low inflation and the higher probability of payback on their government securities by less profligate governments. More recently austerity has been pursued after governments became highly indebted by assuming private debts following banking crises.
According to Mark Blyth, the concept of austerity emerged in the 20th century, when large states acquired sizable budgets. However, Blyth argues that the theories and sensibilities about the role of the state and capitalist markets that underline austerity emerged from the 17th century onwards. Austerity is grounded in liberal economics' view of the state and sovereign debt as deeply problematic. Blyth traces the discourse of austerity back to John Locke's theory of private property and derivative theory of the state, David Hume's ideas about money and the virtue of merchants, and Adam Smith's theories on economic growth and taxes. On the basis of classic liberal ideas, austerity emerged as a doctrine of neoliberalism in the 20th century.
Economist David M. Kotz suggests that the implementation of austerity measures following the 2008 financial crisis was an attempt to preserve the neoliberal capitalist model.
Theoretical considerations
In the 1930s during the Great Depression, anti-austerity arguments gained more prominence. John Maynard Keynes became a well known anti-austerity economist, arguing that "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. According to Paul Krugman, since a government is not like a household, reductions in government spending during economic downturns worsen the crisis.
Across an economy, one person's spending is another person's income. In other words, 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. In the past this has been offset by encouraging consumerism to rely on debt, but after the 2008 crisis, this has looked like a less and less viable option for sustainable economics.
Krugman argues that, if the private sector is unable or unwilling to consume at a level that increases GDP and employment sufficiently, then the government should be spending more in order to offset the decline in private spending. Keynesian theory is proposed as being responsible for post-war boom years, before the 1970s, and when public sector investment was at its highest across Europe, partially encouraged by the Marshall Plan.
An important component of economic output is business investment, but there is no reason to expect it to stabilize at full utilization of the economy's resources. High business profits do not necessarily lead to increased economic growth.
Economists Kenneth Rogoff and Carmen Reinhart wrote in April 2013, "Austerity seldom works without structural reforms – for example, changes in taxes, regulations and labor market policies – and if poorly designed, can disproportionately hit the poor and middle class. Our consistent advice has been to avoid withdrawing fiscal stimulus too quickly, a position identical to that of most mainstream economists."
To help improve the US economy, they advocated reductions in mortgage principal for 'underwater homes' – those whose negative equity can lead to a stagnant housing market with no realistic opportunity to reduce private debts.
Multiplier effects
In October 2012, the IMF announced that its forecasts for countries that implemented austerity programs have been consistently overoptimistic, suggesting that tax hikes and spending cuts have been doing more damage than expected and that countries that implemented fiscal stimulus, such as Germany and Austria, did better than expected.The IMF reported that this was due to fiscal multipliers that were considerably larger than expected: for example, the IMF estimated that fiscal multipliers based on data from 28 countries ranged between 0.9 and 1.7. In other words, a 1% GDP fiscal consolidation would reduce GDP between 0.9% and 1.7%, thus inflicting far more economic damage than the 0.5 previously estimated in IMF forecasts.
In many countries, little is known about the size of multipliers, as data availability limits the scope for empirical research.
For these countries, Nicoletta Batini, Luc Eyraud and Anke Weber propose a simple method—dubbed the "bucket approach"—to come up with reasonable multiplier estimates. The approach bunches countries into groups with similar multiplier values, based on their characteristics, and taking into account the effect of temporary factors such as the state of the business cycle.
Different tax and spending choices of equal magnitude have different economic effects:
For example, the US Congressional Budget Office estimated that the payroll tax has a higher multiplier than does the income tax. In other words, raising the payroll tax by $1 as part of an austerity strategy would slow the economy more than would raising the income tax by $1, resulting in less net deficit reduction.
In theory, it would stimulate the economy and reduce the deficit if the payroll tax were lowered and the income tax raised in equal amounts.
Crowding in or out
The term "crowding out" refers to the extent to which an increase in the budget deficit offsets spending in the private sector. Economist Laura Tyson wrote in June 2012, "By itself an increase in the deficit, either in the form of an increase in government spending or a reduction in taxes, causes an increase in demand". How this affects output, employment, and growth depends on what happens to interest rates:When the economy is operating near capacity, government borrowing to finance an increase in the deficit causes interest rates to rise and higher interest rates reduce or "crowd out" private investment, reducing growth. This theory explains why large and sustained government deficits take a toll on growth: they reduce capital formation. But this argument rests on how government deficits affect interest rates, and the relationship between government deficits and interest rates varies.
When there is considerable excess capacity, an increase in government borrowing to finance an increase in the deficit does not lead to higher interest rates and does not crowd out private investment. Instead, the higher demand resulting from the increase in the deficit bolsters employment and output directly. The resultant increase in income and economic activity in turn encourages, or "crowds in", additional private spending.
Some argue that the "crowding-in" model is an appropriate solution for current economic conditions.