Austerity

By ADAM HAYES
Updated Mar 10, 2020
What Is Austerity?
In economics, austerity is defined as a set of economic policies a government
implements to control public sector debt.

Austerity measures are the response of a government whose public debt is so

large that the risk of default or the inability to service the required payments on
its debt obligations, becomes a real possibility. Default risk can spiral out of
control quickly; as an individual, company or country slips further into debt,
lenders will charge a higher rate of return for future loans, making it more
difficult for the borrower to raise capital.

KEY TAKEAWAYS

 Austerity refers to strict economic policies that a government imposes to

control growing public debt, defined by increased frugality.
 Broadly speaking, there are three primary types of austerity measures:
revenue generation (higher taxes) to fund spending, raising taxes while
cutting nonessential government functions, and lower taxes, and lower
government spending.
 Austerity is controversial and national outcomes from austerity
measures can be more damaging than if they hadn't been used.
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Austerity

How Austerity Works

Austerity only takes place when the gap between government receipts and
government expenditures shrinks. A reduction in government spending
doesn't simply equate austerity measures. 

Broadly speaking, there are three primary types of austerity measures. The
first is focused on revenue generation (higher taxes) and it often even
supports more government spending. The goal is to stimulate growth with
spending and capturing the benefits through taxation. Another kind is
sometimes called the Angela Merkel model — after the German chancellor —
and focuses on raising taxes while cutting nonessential government functions.
The last, which features lower taxes and lower government spending, is the
preferred method of free-market advocates.
The global economic downturn that began in 2008 left many governments with
reduced tax revenues and exposed what some believed were unsustainable
spending levels. Several European countries, including the United Kingdom,
Greece, and Spain, have turned to austerity as a way to alleviate budget
concerns. Austerity became almost imperative during the global recession in
Europe, where eurozone members don't have the ability to address mounting
debts by printing their own currency.

Thus, as their default risk increased, creditors put pressure on certain

European countries to aggressively tackle spending.

Taxes and Austerity 

There is some disagreement among economists about the effect of tax policy
on the government budget. Former Ronald Reagan adviser Arthur Laffer
famously argued that strategically cutting taxes would spur economic activity,
paradoxically leading to more revenue.

Still, most economists and policy analysts agree that raising taxes will raise
revenues. This was the tactic that many European countries took. For
example, Greece increased value-added tax (VAT) rates to 23% in 2010 and
imposed an additional 10% tariff on imported cars. Income tax rates increased
on upper-income scales, and several new taxes were levied on the property.

Government Spending and Austerity 

The opposite austerity measure is reducing government spending. Most
consider this a more efficient means of reducing the deficit. New taxes mean
new revenue for politicians, who are inclined to spend it on constituents.

Spending takes many forms: grants, subsidies, wealth redistribution,

entitlement programs, paying for government services, providing for the
national defense, benefits to government employees, and foreign aid. Any
reduction in spending is a de facto austerity measure.

At its simplest, an austerity program, usually enacted by legislation, may

include one or more of the following austerity measures:

 A cut, or a freeze without raises, of government salaries and benefits

 A freeze on government hiring and layoffs of government workers
 A reduction or elimination of government services, temporarily or
permanently
 Government pension cuts and pension reform
 Interest on newly issued government securities may be cut, making
these investments less attractive to investors, but reducing government
interest obligations.
  Cuts to previously planned government spending programs such as
infrastructure construction and repair, healthcare and veterans' benefits
 An increase in taxes, including income, corporate, property, sales,
and capital gains taxes
 The Federal Reserve may either reduce or increase the money
supply and interest rates as circumstances dictate to resolve the crisis.
 Rationing of critical commodities, travel restrictions, price freezes and
other economic controls (particularly in times of war)

Examples of Austerity Measures 

Perhaps the most successful model of austerity, at least in response to a
recession, occurred in the United States between 1920 and 1921. The
unemployment rate in the U.S. economy jumped from 4% to almost 12%. Real
gross national product (GNP) declined almost 20%—greater than any single
year during the Great Depression or Great Recession.

President Warren G. Harding responded by cutting the federal budget by

almost 50%. Tax rates were reduced for all income groups, and the debt
dropped by more than 30%. In a speech in 1920, Harding declared that his
administration "will attempt intelligent and courageous deflation, strike at
government borrowing...and will attack the high cost of government with every
energy and facility."

The Risks of Austerity

While the goal of austerity measures is to reduce government debt, their
effectiveness remains a matter of sharp debate. Supporters argue that
massive deficits can suffocate the broader economy, thereby limiting tax
revenue. However, opponents believe that government programs are the only
way to make up for reduced personal consumption during a recession. Robust
public sector spending, they suggest, reduces unemployment and therefore
increases the number of income-tax payers. 

Economists such as John Maynard Keynes, a British thinker who fathered the
school of Keynesian economics, believe that it is the role of governments to
increase spending during a recession to replace falling private demand. The
logic is that if demand is not propped up and stabilized by the government,
unemployment will continue to rise and the economic recession will be
prolonged

Austerity runs contradictory to certain schools of economic thought that have

been prominent since the Great Depression. In an economic downturn, falling
private income reduces the amount of tax revenue that a government
generates. Likewise, government coffers fill up with tax revenue during an
economic boom. The irony is that public expenditures, such as unemployment
benefits, are needed more during a recession than a boom.
Limits to Keynesian Economics
Countries that belong to a monetary union, such as the European Union, do
not have as much autonomy or flexibility when boosting their economy during
a recession. Autonomous countries can use their central banks to artificially
lower interest rates or increase the money supply in an attempt to encourage
the private market into spending or investing their way out of a downturn.

For instance, the United States’ Federal Reserve has engaged in a dramatic
program of quantitative easing since November 2009. Countries such as
Spain, Ireland, and Greece did not have the same financial flexibility due to
their commitment to the euro, although the European Central Bank (ECB) also
enacted quantitative easing, though later than in the U.S.

Greece's Austerity Measures 

Mainly, austerity measures have failed to improve the financial situation in
Greece because the country is struggling with a lack of aggregate demand. It
is inevitable that aggregate demand declines with austerity. Structurally,
Greece is a country of small businesses rather than large corporations, so it
benefits less from the principles of austerity such as lower interest rates.
These small companies do not benefit from a weakened currency, as they are
unable to become exporters.

While most of the world followed the financial crisis in 2008 with years of

lackluster growth and rising asset prices, Greece has been mired in its own
depression. Greece's gross domestic product (GDP) in 2010 was $299.36
billion. In 2014, its GDP was $235.57 billion according to the U.N. This is
staggering destruction in the country's economic fortunes, akin to the Great
Depression in the United States in the 1930s.

Greece's problems began following the Great Recession as the country was
spending too much money relative to tax collection. As the country's finances
spiraled out of control and interest rates on sovereign debt exploded higher,
the country was forced to seek bailouts or default on its debt. Default carried
the risk of a full-blown financial crisis with a complete collapse of the banking
system. It would also be likely to lead to an exit from the euro and the
European Union.

Implementation of Austerity
In exchange for bailouts, the EU and European Central Bank (ECB) embarked
on an austerity program that sought to bring Greece's finances under control.
The program cut public spending and increased taxes often at the expense of
Greece's public workers and was very unpopular. Greece's deficit has
dramatically decreased, but the country's austerity program has been a
disaster in terms of healing the economy.
The austerity program compounded Greece's problem of a lack of aggregate
demand. Cutting spending led to even lower aggregate demand, which made
Greece's long-term economic fortunes even drier, leading to higher interest
rates. The right remedy would involve a combination of short-term stimulus to
shore up aggregate demand with long-term reforms of Greece's public sector
and tax collection departments.

Structural Issues
The major benefit of austerity is lower interest rates. Indeed, interest rates on
Greek debt fell following its first bailout. However, the gains were limited to the
government having decreased interest rate expenses. The private sector was
unable to benefit. The major beneficiaries of lower rates are large
corporations. Marginally, consumers benefit from lower rates, but the lack of
sustainable economic growth kept borrowing at depressed levels despite the
lower rates.

The second structural issue for Greece is the lack of a significant export
sector. Typically, a weaker catalyst is a boost for a country's export sector.
However, Greece is an economy composed of small businesses with fewer
than 100 employees. These types of companies are not equipped to turn
around and start exporting. Unlike countries in similar situations with large
corporations and exporters, such as Portugal, Ireland or Spain, which have
managed to recover, Greece re-entered a recession in the fourth quarter of
2015. 

Reference:
https://www.investopedia.com/terms/a/austerity.asp