Austerity

By Alberto Alesina, Carlo Favero, Francesco Giavazzi

Austerity (2019) uses data analysis to look at one of the most controversial topics in economics today.
An analysis of several countries’ austerity policies over the past several decades reveals that cutting
spending can actually help the economy expand.

Who is it for?

🔅 Economists keen to learn more about austerity

🔅 Politicians looking to brush up on their economics

🔅 Anyone who wants to understand the numbers behind government policy

⏱ 13-minute read

📖 9 blinks

#blinkist free daily

Austerity

Blinkist Free DailyAugust 09, 2020

Alberto Alesina, Carlo Favero, Francesco Giavazzi

1/9

What’s in it for me? Discover the numbers behind austerity policies.

Austerity is a controversial subject, and one that economists have been arguing about for a long time.
Since the financial crisis of 2008, the issue has become even more urgent. Simply put, how do you
reduce a government’s deficit without ruining the economy?

To find the answer, academics Alberto Alesina, Carlo Favero, and Francesco Giavazzi turned to data.
They compiled a huge dataset that included austerity cases in 16 developed countries, from the 1980s to
the 2010s, and worked out the effect those policies had.
The results were surprising. Austerity wasn’t always the political kiss of death it’s commonly assumed to
be. In some cases, it actually worked quite well, and even led to governments being reelected.

However, the authors discovered that there are two different types of austerity, and that they’re not the
same at all. In fact, as you’ll discover in these blinks, cutting government spending produces very
different results than raising taxes.

In these blinks, you’ll learn

Why politicians shouldn’t fear austerity measures;

Where Keynes went wrong with his views on austerity; and

What happened in Greece after the financial crisis.

2/9

If it’s done correctly, austerity isn’t always bad news.

Since the financial crisis of 2008, everyone’s been talking about “austerity” – not just economists, but
the general public too. But what exactly does it mean?

Simply put, austerity is a type of government policy that aims to reduce a budgetary deficit – that is,
when government spending is more than the revenue it receives – so that the level of debt is stable.
There are two ways governments can do this: raising taxes and cutting spending.

Although some economists and politicians view austerity as a sensible policy, it can be unpopular with
the general public. And yet evidence shows that it is possible to be reelected after introducing
controversial austerity measures. What’s more, austerity can even be good for the economy as a whole.

The key message here is: If it’s done correctly, austerity isn’t always bad news.

In an ideal world, there’d be no need for austerity. Governments would accumulate a surplus when the
economy is booming, and run a deficit when it’s in recession – just like a seasonal worker might save
heavily when money comes in and use the savings when work dries up. Overall, the surplus and the
deficit would balance each other out, eliminating the need for drastic austerity measures.
But that’s not how it tends to play out. First of all, it’s common for governments to keep borrowing even
during an economic boom. And secondly, an unexpected crisis – be it a pandemic or a war – often
requires high levels of spending.

For countries like Italy and Greece, the Great Recession of 2008 was especially terrible because they had
been building up far too much debt in the years leading up to the crisis. So, when the sudden shock of
2008 arrived, they were in two kinds of trouble at once.

In cases like that, the need for austerity is clear. And even though austerity measures can go wrong, as in
the case of Greece, a correctly managed program of austerity can succeed in lowering the deficit
without doing serious damage to the economy.

How is this possible? Well, through detailed analysis of a large dataset, the authors got closer to an
answer. Despite the complexity of the question, they found that one point tends to hold true: spending
cuts often lead to better outcomes than tax increases.

3/9

Previous work on austerity hasn’t factored in concerns like expectation, incentive, and confidence.

John Maynard Keynes was an influential 20 th-century economist whose work is still considered relevant
today.

According to him, cutting government spending has a multiplier effect on the economy – the initial cut
creates an even greater negative impact on gross domestic product (also known as GDP). Meanwhile,
raising taxes also causes a slight drop in GDP – because people have less disposable income – but the
effect isn’t as pronounced.

Keynes’s simple model has been updated and expanded since the 1920s and 1930s, but the essence of
the argument is still widely believed. However, the authors suggest that even revised versions don’t
accommodate important considerations – specifically, that announcements about austerity don’t just
affect the numbers. They also affect people’s attitudes and expectations for the future.

The key message here is: Previous work on austerity hasn’t factored in concerns like expectation,
incentive, and confidence.
Let’s consider expectation. What people do today isn’t just determined by the present. We also make
decisions based on what we think is going to happen in the future. That, the authors argue, is one
reason that spending cuts can actually boost the economy.

When government programs are cut, people may well expect taxes to come down in the future since the
government won’t need as much money. And so people will spend more today, expecting to pay less tax
later. On the other hand, if people expect taxes to go up in the future, they won’t always wait for the
change to kick in. They’ll start saving right away.

Of course, this only applies to people with disposable income, since those living paycheck to paycheck
aren’t able to save. However, when more people are able to save, the effects of austerity are shaped by
future expectations.

Raising taxes also affects incentive. Higher taxes could make it less attractive for people to work,
particularly if they’re a household’s second earner or approaching retirement. On the other hand,
cutting transfer payments, such as benefits, may increase incentives by encouraging people to work.

Another concern is confidence. Investors will only want to support a government that they believe has
control over its economy. Spending cuts can send a clear signal that the state is making responsible
decisions – thus boosting investor confidence. However, raising taxes doesn’t improve investor
confidence – at least not according to the authors’ analysis, as we’ll soon discover.

4/9

A narrative approach to the data can shed new light on the effects of austerity.

Many previous attempts to analyze austerity ran into the same problem: it’s very hard to measure.

And not only because of the influence of expectation, incentive, and confidence that we discussed in the
previous blink. It’s also hard to work out whether a change in a country’s finances was caused by
austerity at all. For example, it’s possible that a country’s deficit may decrease simply because of
increased growth.
What makes the analysis even trickier is the fact that changes from austerity typically take place over
the course of several years, sometimes with policy alterations along that way. That’s why the authors
needed a better way to understand what was really going on.

The key message here is: A narrative approach to the data can shed new light on the effects of austerity.

Factoring in all of these complex motivations, the authors adopt what they call a narrative approach.
This allows them to see more accurately how a government’s austerity policy affects the economy.

The authors’ dataset was drawn from 16 generally wealthy countries, predominantly in Europe but also
including the United States, Canada, Australia, and Japan. They looked at episodes of fiscal consolidation
– another term for austerity – between 1981 and 2014. Alongside cases from the 1980s and 1990s, a
considerable number of case studies came from the period after the Great Recession of 2007–2009.

Each plan within the dataset was labeled as either expenditure-based (meaning it involved cutting public
spending) or tax-based (meaning it involved raising taxes). Of course, the full picture was more complex
than this, because a typical austerity plan has a mixture of both. However, most of the time, a clear
majority of the savings came from one side or the other, and the results held up even after leaving out
cases where it was close to a 50/50 split.

The data only included cases where governments specifically introduced policies aimed at reducing the
deficit, and the authors recorded when the austerity measures were announced as well as when they
were actually introduced. That’s why their approach is “narrative” – rather than imagining that policy
changes come out of the blue, it acknowledges that attitudes change the moment that policies are
announced.

5/9

Expenditure-based austerity can yield positive results.

As we’ve already discussed, there are two types of austerity: expenditure-based austerity focuses on
reducing government spending while tax-based austerity increases government income. These
fundamental differences have very different effects on the economy.

According to the authors, expenditure-based austerity usually has a far milder effect than tax hikes. In
some cases, it can even lead to a growth in GDP.
The authors call this expansionary austerity – when the Keynesian multiplier effect happens in reverse,
and a drop in spending leads to economic growth.

The key message here is: Expenditure-based austerity can yield positive results.

Expansionary austerity is a controversial concept that runs against economic theory, and it certainly
doesn’t happen every time a government reduces spending. But even though expansionary cases aren’t
the norm, they aren’t truly exceptional either.

One example concerns Austria in the 1980s. In the first three years of the decade, the government
introduced a range of austerity measures, with 74 percent of these cuts being expenditure-based. With
cuts totaling 2.5 percent of GDP the economy slowed down at first. But then GDP per capita increased
by 2 percent in 1982 and 3 percent in 1983.

Canada also achieved expansionary austerity in the 1990s. Working from an initial debt-to-GDP ratio of
80 percent, Prime Minister Brian Mulroney, a Progressive Conservative, stopped the growth of
government spending and made some cuts. The Liberals defeated him in a 1993 election, but they were
pro-austerity, too, and further spending cuts followed. All in all, despite more and more cuts, averaging
around 0.5 percent of GDP per year, output per capita kept growing, and starting in 1996 the debt-to-
GDP ratio began to fall.

So, while spending cuts may lead to lower output in some areas, increased demand in other areas could
more than compensate for that. In other words, if conditions are right, expansionary austerity is
possible.

In fact, by combining all their data to construct an average case, the authors found that expenditure-
based austerity plans usually cause only a slight drop in GDP after one year, which then stabilizes to a
slightly smaller drop in the years after that. And even when expenditure-based austerity isn’t
expansionary, its effects are still preferable to those of tax-based austerity, as we’ll find out in the next
blink.

6/9

Tax-based austerity often leads to deeper recessions.

When the authors constructed their average case, they also looked at the effect of tax-based austerity
on GDP per capita. In this model, the initial effect of a tax increase was a notable drop in GDP, and that
drop became even greater in later years.

According to the data analysis, tax-based austerity pushes economies into recession for several years.
This is an especially striking result when compared to the mild effect of expenditure-based austerity.

The key message here is: Tax-based austerity often leads to deeper recessions.

Just look at Ireland between 1982 and 1986. The government planned to eliminate the deficit altogether
by 1987, and the main way they tried to do this was through tax increases, leaving public spending
mostly untouched. But this barely stopped the deficit from growing. To make matters worse, it soon
became apparent that the goal of eliminating the deficit simply wasn’t achievable, which caused
concern among the general public.

Overall, Ireland’s debt-to-GDP ratio ended up growing – from 74 percent in 1982 to 107 percent in 1986.
It was only in 1987 that the government began making spending cuts, at which point the economy
started to grow straight away.

Something similar happened in Portugal, which, in 1983, introduced a program that aimed to cut the
budget deficit by 2 percent of GDP. The country’s output per capita had been growing when they
introduced the measures – 60 percent of which were tax increases – but then declined for two
consecutive years. Portugal also attracted substantially less investment. The result? GDP fell by 2.3
percent in 1984, even though the average across Europe was growing.

In the authors’ dataset, the results are clear: tax-based austerity leads to a decrease in output. Although
individual cases differ in the specifics, this key result can’t be explained through factors like monetary
policy, fluctuating exchange rates, or structural reforms introduced alongside the austerity measures.
Regardless of these factors, tax-based austerity generally leads to the same negative result.

But why is tax-based austerity considerably worse for the economy than expenditure-based austerity?
There are a variety of reasons, but one of the most important concerns confidence, which we
introduced in an earlier blink.
To recap, cutting expenditure often leads to increased confidence in the government, making it more
appealing to investors. Tax increases, on the other hand, reduce the appeal to investors because of the
negative effect on wealth.

7/9

Austerity played a key role after the 2008 financial crash – for better and for worse.

All the examples so far have been from the 1980s and 1990s. But nowadays, when people think about
austerity, they think of more recent times. After all, the financial crisis of 2008 led to massive austerity
programs in the years that followed.

Since then, the debate around austerity has been passionate, and often ideologically motivated. That’s
why the authors offer their data analysis as a look at austerity focused on facts – even though these
facts are complex and differ widely from one country to the next.

The key message here is: Austerity played a key role after the 2008 financial crash – for better and for
worse.

Let’s start with the United Kingdom. Its immediate reaction to the 2008 crash was to introduce
expansionary fiscal policies. Only in 2010 did the new coalition government introduce austerity
measures, mostly in the form of spending cuts. In total, the measures amounted to almost 3 percent of
GDP over five years.

Growth in output per capita was -5 percent in 2009, but the six-year average between 2009 and 2015
was +1.6 percent – a considerable turnaround. What’s more, the Conservative government behind the
measures did well in the 2015 election, gaining a majority.

The story of Greece is not so positive. After enjoying rapid growth since the late 1990s, Greece was
devastated by the shock of 2008. From 2010 to 2014, the government made extraordinarily high cuts
amounting to 20 percent of GDP. It didn’t work and the debt-to-GDP ratio soared to 180 percent in
2014.

Why did things go so wrong?

In truth, savings of that magnitude were never achievable, and international bodies were harsh in
forcing these measures onto the country. Also, with default ruled out as an alternative, the fraught
international situation made matters worse.

The Greek economy was in dire straits when austerity began – hardly the perfect time to slash the
budget. Still, the example of Greece raises an important question: When is the right time to introduce
austerity measures?

The jury is still out on that question; however, according to the authors, the precise moment when an
austerity program is introduced isn’t necessarily the most important consideration. Of far greater
significance is whether the austerity package is made up of tax increases or spending cuts.

8/9

The politics of austerity is complex but it isn’t necessarily a political “kiss of death.”

If you’re looking for a surefire way to electoral success, raising taxes and cutting public spending
probably isn’t the way to go. Understandably enough, voters like low taxes and well-funded services,
which often means that they reward short-term policies without considering the long-term costs.

That’s the conventional wisdom, anyway. But, as the authors suggest, governments can do well at the
polls even after austerity measures are introduced.

The key message here is: The politics of austerity is complex but it isn’t necessarily a political “kiss of
death.”

There are always many factors that determine the outcome of an election – beyond austerity or even
the economy as a whole. Still, the widely held assumption that austerity is a recipe for electoral failure is
probably not true at all.

In 1997, Canada reelected its pro-austerity government, as did Sweden in 1998 and Finland in 1999.
And, as already mentioned, the UK’s Conservative party increased its share of the vote after five years of
austerity in 2015. So, while there’s no universal rule, it’s clear that not every austerity program leads to
a change in government.
Even more complex than winning an election is running a country. That complexity is one reason why
governments continue to implement tax-based austerity programs, despite evidence of their negative
effect.

Why don’t governments always use spending cuts instead? Besides being difficult to implement, they
can throw up challenges that aren’t just about numbers. After all, they have to come from particular
parts of the budget, and some politicians will argue strongly against them – both because no politician
likes to have their own budget cut, and because they may sincerely believe in the importance of a
particular scheme.

Compared to the political maneuvering that spending cuts require, tax increases can seem relatively
straightforward. Plus, their impact is often more widely spread among a population. In fact, if a country
is already in crisis, tax increases may be the only possible option.

The bottom line is that austerity measures aren’t easy to implement, and some situations – like the one
Greece found itself in – may prove particularly difficult. However, as the authors argue, many
assumptions about austerity simply aren’t true. In some situations, if it’s done right, austerity can work.

9/9

Final summary

The key message in these blinks:

Austerity has a bad reputation, but, according to the authors’ carefully compiled data, it can be good for
a country’s economy. Of the two types of austerity, expenditure-based austerity generally leads to far
better results than tax-based austerity. Spending cuts can even lead to the economy expanding, while
tax hikes generally have a decidedly negative impact.