Thursday, February 14, 2013


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.


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 if 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 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 stimulate the economy and reduce the deficit if the payroll tax were lowered and the income tax raised in equal amounts.

Savings Surplus Or Investment Deficit

U.S. savings and investment; savings less investment is the private sector financial surplus

One reason austerity can be counterproductive in a downturn is due to a significant private sector financial surplus, in which consumer savings is not fully invested by businesses. In a healthy economy, private sector savings placed into the banking system by consumers is borrowed and invested by companies. However, if consumers have increased their savings but companies are not investing the money, a surplus develops. Business investment is one of the major components of GDP.

For example, a U.S. private sector financial deficit from 2004 to 2008 transitioned to a large surplus of savings over investment that exceeded $1 trillion by early 2009 and remained above $800 billion as of September 2012. Part of this investment reduction related to the housing market, a major component of investment. This surplus explains how even significant government deficit spending would not increase interest rates (because businesses still have access to ample savings if they choose to borrow and invest it, so interest rates are not bid upward) and how Federal Reserve action to increase the money supply does not result in inflation (because the economy is awash with savings with no place to go).

Economist Richard Koo described similar effects for several of the developed world economies in December 2011: "Today private sectors in the U.S., the U.K., Spain, and Ireland (but not Greece) are undergoing massive deleveraging [paying down debt rather than spending] in spite of record low interest rates. This means these countries are all in serious balance sheet recessions. The private sectors in Japan and Germany are not borrowing, either. With borrowers disappearing and banks reluctant to lend, it is no wonder that, after nearly three years of record low interest rates and massive liquidity injections, industrial economies are still doing so poorly. Flow of funds data for the U.S. show a massive shift away from borrowing to savings by the private sector since the housing bubble burst in 2007. The shift for the private sector as a whole represents over 9 percent of U.S. GDP at a time of zero interest rates. Moreover, this increase in private sector savings exceeds the increase in government borrowings (5.8 percent of GDP), which suggests that the government is not doing enough to offset private sector deleveraging."

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.

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 (i.e., 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.[20] 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. Eurostat reported that Eurozone unemployment reached record levels in September 2012 at 11.6%, up from 10.3% the prior year. Unemployment varied significantly by country.

United States

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 1990's, 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.


Britain had a negative result from its austerity policies, with the deficit remaining high despite spending cuts and the debt to GDP ratio rising. Before the May 2010 election, the U.K.’s economy appeared to be slowly recovering from the deep slump of 2008-09 that followed the global financial crisis. Gordon Brown’s Labour government had introduced a fiscal stimulus to help turn the economy around. GDP was growing at an annual rate of about 2.5%. Once cuts in spending started to be felt in Q4 2010, growth turned negative and a double-dip recession began that lasted into 2012. While GDP did expand in Q3 2012, the Office of Budget Responsibility (OBR) expects another decline in Q4 2012. For 2013, the OBR is forecasting GDP growth of just 1.3%. With the economy so weak, the OBR says that the unemployment rate will rise from 8.0% to 8.2% in 2013. Back in 2009, the OBR predicted that by the end of 2013-2014, the deficit would be 3.5% GDP. In December 2012, OBR projected that the actual figure will be 6.1% GDP. The debt-to-GDP ratio, which was expected to peak at 70%, hit 75% in 2012, and is forecast to climb to 80% in 2015-2016.


In April and May, 2012, France held a presidential election in which the winner Fran├žois Hollande had opposed austerity measures, promising to eliminate France's budget deficit by 2017 by canceling recently enacted tax cuts and exemptions for the wealthy, raising the top tax bracket rate to 75% on incomes over a million euros, restoring the retirement age to 60 with a full pension for those who have worked 42 years, restoring 60,000 jobs recently cut from public education, regulating rent increases; and building additional public housing for the poor. In June, Hollande's Socialist Party won a supermajority in legislative elections capable of amending the French Constitution and enabling the immediate enactment of the promised reforms. French government bond interest rates fell 30% to record lows, less than 50 basis points above German government bond rates.


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.

In October 2012, the International Monetary Fund announced that its forecasts for countries which implemented austerity programs have been consistently overoptimistic, suggesting that tax hikes and spending cuts have been doing more damage than expected, and countries which implemented fiscal stimulus, such as Germany and Austria, did better than expected. This data has been scrutinized by the Financial Times, which found no significant trends when outliers like Germany and Greece are excluded. Determining the multipliers used in the research to achieve the results found by the IMF were also described as an "exercise in futility" by Professor Carlos Vegh of the University of Michigan. Also, Barry Eichengreen of UC Berkeley and Kevin H O’Rourke of Oxford write that the IMF's new estimate of the extent to which austerity restricts growth was much lower than historical data suggests.

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.

Balancing Stimulus And Austerity

Strategies that involve short-term stimulus with longer-term austerity are not mutually exclusive. Steps can be taken in the present that will reduce future spending, such as "bending the curve" on pensions by reducing cost of living adjustments or raising the retirement age for younger members of the population, while at the same time creating short-term spending or tax cut programs to stimulate the economy to create jobs.

IMF managing director Christine Lagarde wrote in August 2011: "For the advanced economies, there is an unmistakable need to restore fiscal sustainability through credible consolidation plans. At the same time we know that slamming on the brakes too quickly will hurt the recovery and worsen job prospects. So fiscal adjustment must resolve the conundrum of being neither too fast nor too slow. Shaping a Goldilocks fiscal consolidation is all about timing. What is needed is a dual focus on medium-term consolidation and short-term support for growth. That may sound contradictory, but the two are mutually reinforcing. Decisions on future consolidation, tackling the issues that will bring sustained fiscal improvement, create space in the near term for policies that support growth."

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".

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