Austerity

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Last Updated:November 28, 2023

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What is Austerity?

Austerity refers to a set of political and economic policies to reduce deficits by cutting spending, increasing taxes, or combining the two.

There are three types of measures:

Raising taxes to finance spending.
Tax increases and spending cuts.
Less government spending and lower taxes.

Many governments resort to these measures when borrowing or paying back loans becomes difficult. As a result, government revenues can be brought closer to its expenditures through these measures, which helps reduce the budget deficit.

Those who support these measures argue that they lower borrowing requirements and demonstrate the fiscal discipline of government to creditors and credit rating agencies, thereby making borrowing easier and cheaper.

How Austerity Works

It is well-known that rigid policies that reduce government spending will increase unemployment in the short term. Typically, both the public and private sectors experience reductions in employment.

It has been observed that such policies enacted through tax hikes can reduce consumption by reducing disposable household income.

There is a risk that reduced government spending can harm the growth of the GDP in the short term because it is itself a component of the GDP.

Reduced government spending on a longer-term basis can reduce GDP growth as well.

Cutting education spending, for example, will impair the nation's workforce's ability to carry out high-skilled jobs, or it will impose greater costs on businesses than they saved by reducing taxes.

During harsh economic conditions, reduced government spending may lead to higher debt-to-GDP ratios than a higher budget deficit, which could lead to a higher debt-to-GDP percentage.

As a result of the measures taken following the Great Recession, unemployment increased, and GDP growth slowed in many European countries. Despite a reduction in budget deficits, the debt-to-GDP ratio increased.

Poignancy can sometimes stimulate economic growth, especially when the output gap is low. However, increasing short-term deficit spending (stimulus) in an economy at or near capacity can result in rising interest rates, reducing private investment and economic growth.

Note

A stimulus can increase employment and output when there is excess capacity. According to Alberto Alesina, Carlo Favero, and Francesco Giavazzi, it may be expansionary when coupled with higher aggregate demand (private consumption, private investment, and exports).

What constitutes austerity?

Some of them are as follows:

1. Spending Cuts

It is a concept that implies real cuts in public spending. Others refer to it as policies even if government spending has been limited.

Suppose, for example, government spending has increased by 3% over the past decade. Government spending is no longer rising at the same pace. The government freeze on public sector spending may lead some to label it austerity.

2. Spending Cuts and Automatic Stabilisers

Analyzing government spending on its own could be misleading. As a result of lower tax revenues and higher unemployment benefits costs, the government deficit will automatically increase during a recession.

The overall impact on government spending would be zero if the government increased welfare benefits by £1bn but cut public sector investment by the same amount.

The cut in investment spending, however, may be perceived as harsh. The cyclically adjusted deficit is another way to analyze this.

An adjustment is made for cyclical variations in government borrowing. The shrinking of the cyclically adjusted deficit implies austerity. (Economists look at structural budget deficits and argue that asperity has taken place).

3. Fall in Private Sector Spending

The private sector has failed to replace its lost spending. In Keynesian thinking, it is a policy that can't compensate for a drop in private-sector expenditures. Therefore, it can't close the output gap if there is a decline in private-sector spending.

Defined here in a very broad sense because it implies that it is possible even if the federal government spends more but fails to close the negative output gap.

4. Economic Growth

If economic growth is not promoted, the output gap is not closed. In other words, it does not promote economic growth.

In such an instance, If the government fails to target higher growth and close the negative output gap, it would be pursuing asperity. Such a definition is somewhat vague.

5. Fiscal Policy

Generally, it refers to the government's fiscal policy - its budgetary position. But, more often than not, it refers to policies that reduce aggregate demand or lead to unemployment.

It can be argued that tight monetary policy (high-interest rates) and an overvalued exchange rate (e.g., a country's currency will become overvalued when converting to the Euro) are part of a general economic policy of austerity.

6. Public Spending Cuts

A perceived cut in public spending may also be referred to it. One example is the U.K., where real expenditure on the NHS has increased. However, as a share of national income, the real spending on the NHS has decreased.

When combined with the aging population, more people may need healthcare services, increasing the pressure on health services, which can be viewed as prudence measures.

Types of Austerity

The three primary measures can be broadly divided into the following categories:

1. Increasing Taxes

Generally, when the government raises more taxes than it spends, it reduces income and slows economic growth. Therefore, tax increases are recommended to stabilize an overheated economy.

Increasing taxes to generate revenue often leads to increased government spending. To maximize benefits, taxation is used to stimulate growth.

2. Angela Merkel's model

This measure is named after the German chancellor and aims to increase taxes while cutting non-essential government functions. There was only one time during Chancellor Merkel's 16-year tenure when she cut taxes for business.

That was in 2008, when the corporate income tax was lowered to 30 percent. Germany has since then fallen back to having one of the most oppressive tax regimes in the world, not only for businesses but also for self-employed entrepreneurs and employees.

3. Reduce taxes and reduce government spending

This is the method preferred by free-market advocates. In contrast, reducing taxes has the opposite effect on income, demand, and GDP. A tax cut will boost all three, which is why people cry for one when the economy is struggling.

Note

Lower taxes lead to more disposable income. Ultimately, it leads to increased spending (GDP) and production (demand).

Taxes

Economics differs in its assessments of the effect of tax policy on government expenditures. For example, Arthur Laffer, a former Reagan adviser, argued that cutting taxes strategically would spur economic growth, bringing in more revenue.

Despite this, economists and policy analysts believe increasing taxes will lead to higher revenue. It is a tactic that many European countries have used in the past.

A case in point is Greece, which increased the value-added tax rates from 19% to 23% in 2010. In addition to raising income tax rates on the upper-income scales, the government has added new property taxes.

Reducing Government Spending

In the opposite direction, such prudence measures are taken to reduce government spending.

Most economists consider this one of the most efficient ways to reduce the deficit. In addition, tax increases result in new income for politicians, which can be spent on constituents.

In addition to grants, subsidies, and wealth redistribution, other spending by the government includes:

Paying for services.
Paying for national defense.
Providing for employee benefits.
Providing for foreign aid.

Any reduction in spending is a de facto asperity measure. Prudence measures are usually enacted through legislation and typically include one or more of the following measures:

Government salaries and benefits are cut or frozen.
Government hiring and layoffs are frozen.
The reduction or elimination of government services, either temporarily or permanently.
The reduction or elimination of pensions and pension reforms.
Investors may be discouraged from investing in newly issued government securities because interest rates may be reduced.
Reduced government spending on health and veterans' benefits, infrastructure construction, and repair.
Tax increases, including income, corporate, property, sales, and capital gains taxes
The Federal Reserve may reduce or increase the money supply and interest rates depending on the circumstances to resolve the crisis.
During the war, there was often rationing of essential commodities, travel restrictions, and price freezes.

Advantages of Austerity Policies

The primary objective of implementing these measures into a country's fiscal policy is to decrease the country's debt.

Many economists, however, contend that such a policy may not be effective, as cuts to government spending include reducing welfare benefits, healthcare programs, and other essential services the government provides.

Additionally, these measures tend to impact those earning a low wage more than those earning a high salary.

In this way, such policies tend to damage the section of society that requires the most assistance when a period of economic instability occurs.

As a result of such policies, proponents claim that a sustained increase in government debt can cripple a country's economy. According to them, these measures are a necessary evil.

Criticisms Of Austerity

The classical Keynesian Theory, developed in the aftermath of the Great Depression, advocated for the government to spend more and reduce taxes during recessionary times.

According to this theory, a recession can be cured simply by spending its way out.

Anti-measures would boost employment and aggregate demand in the economy and would, as a result, increase employment (particularly in government services).

The effectiveness of such policies remains a hotly debated topic. Those in favor argue that this can stifle the broader economy, limiting tax revenue. At the same time, opponents claim that government programs are the only way to compensate for lower personal consumption during a recession.

Many people believe that cutting government spending leads to large-scale unemployment. But conversely, they argue that robust public expenditures will reduce unemployment and increase tax revenues.

Although such measures may help restore the health of a nation's economy, the fact remains that reduced government spending may result in high unemployment.

Some economists, including John Maynard Keynes, a British economist who founded the Keynesian School of Economics, believe that it is the role of government to increase the level of spending in recessions to replace falling private demand.

The logic behind this argument is that unemployment will continue to rise if demand is not propped up and stabilized by the government. As a result, the recession will last longer than it should.

However, it is important to remember that it contradicts some schools of economic thought that have been dominant since the Great Depression.

In times of economic downturns, falling personal income reduces the amount of revenue generated by the government due to lower taxes.

Moreover, when the economy booms, the government collects a large amount of tax revenue. However, it is ironic that during a recession, the need for public expenditures, such as unemployment benefits, is higher than during an economic boom.

Inequality

In the U.K., the poorest tenth of the population was the worst hit by asperity measures due to cuts in public services and changes to taxes and welfare. As a result, their net income fell by 38 percent during 2010-15.

The richest tenth of the population lost the least, with an income decline of only 5%. There is also evidence that the super-rich has done much better since the economic crisis.

Moreover, despite measures designed to stimulate the economy, the richest have reaped significant gains – the richest five percent of households hold forty percent of the assets that gained value directly from quantitative easing.

In the meantime, the poorest tenth is still getting even less. Policies meant to increase the share of taxes paid by the richest have been watered down, with the government reducing the top income tax rate from fifty percent to forty-five percent.

Examples of Austerity

Some of the examples are:

1. United States

Asperity emerged as the most successful model from the 1920 and 1921 recessions that began in the United States.

During this period, the unemployment rate in the U.S. jumped from 4% to almost 12%. The U.S. economy lost 20% of its gross domestic product (GDP), more than any single year during the Great Depression or Great Recession.

After the Great Depression, Warren G. Harding responded by cutting the federal budget by more than 50%. In addition, all income groups had their tax rates reduced, and the national debt decreased by over 30%.

Harding stated that through "intelligent and courageous deflation," his administration would aim to reduce government borrowing.

2. United Kingdom

After the recession of 2008, the fiscal policy of the United Kingdom aimed to reduce government debt as much as possible. As a result, public spending was drastically reduced, and taxes were increased to reduce the deficit in the budget.

Even though the National Health Service (NHS) and education sectors were largely spared such cuts, the policy was severely criticized by economists and politicians.

The European Union forced the Greek government to implement prudence measures within the country's domestic economy after the 2011 eurozone crisis.

In the years before the 2011 recession, Greece had a very large budget deficit. As a result, a directive from the European Union required all non-essential government-funded projects to be discontinued. In addition, the government imposed higher taxes.

As a result of major changes made to the Greek tax system, many loopholes that previously allowed Greek businesses to evade taxes were closed.

The country's government services also observed a large reduction in administrative staff. In addition, the Greek government sold several large government assets to private citizens throughout Europe, such as state-owned buildings.

3. Spain

The Spanish government also introduced these measures in 2011/12. As part of these measures, tax rates were raised, and government expenditures were cut. It is noteworthy that the Spanish government imposed heavy taxes on tobacco consumption.

Austerity Other Concepts

Some of the other concepts are:

1. Self-defeating

Such a policy fails to reduce budget deficits by reducing spending and raising taxes. This is because spending reductions have a large negative impact on real GDP.

The decline in government spending results in a decrease in aggregate demand, which results in a reduction in real GDP. As a result of the decrease in real GDP, tax revenues fall, and expenditures on welfare rise.

Therefore, even though the government has cut other expenditures, the budget situation will not improve because the reduced spending will be overwhelmed by the increase in recession-related borrowing.

2. The Multiplier Effect

It has an impact on the economy based on the multiplier effect. In the case of a $1bn cut to government spending and a £2bn drop in real GDP, we say there is a fiscal multiplier of two, and the policy is likely to cause a deep recession.

When there is a fiscal multiplier of 0.5, this means that if government spending falls by £1bn and real GDP only falls by £0.5bn, the policies have had little impact on real GDP.

3. Austerity Bomb

A rapid period of fiscal consolidation results in a sharp fall in real GDP.

The phrase "austerity bomb" appears to have been coined by Brian Beutler of Talking Points Memo, who says that what is scheduled to happen at the end of the year will be an "austerity bomb."

A more accurate description is a "fiscal cliff." This fiscal cliff makes people think an excessive deficit is an issue when it's about excessive deficits.

Every time someone warns about the dangers of frugality, they acknowledge that Keynesians were right all along, that cutting spending and raising taxes on ordinary workers in a depressed economy is destructive, and that the opposite should be done.