What is 'Austerity'
Austerity refers to a state of frugal spending. In the financial sector austerity is used to describe the measures that governments take to reduce their budget deficits, either by raising taxes or reducing government spending. Austerity measures are generally unpopular with citizens of a country but are at times necessary to avoid the negative effects of a growing deficit.
BREAKING DOWN 'Austerity'
Austerity measures generally 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.
Raising taxes or reducing expenditures on public projects and programs are the unpopular routes that a government must take to reel in their deficits. Many countries, including European nations such as Greece, Spain and Ireland, were forced into a mode of austerity to stabilize their economies following the massive credit crisis and global recession of 2008, which left their balance sheets crippled.
Controversy Surrounding Austerity Measures
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.
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 in order 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.
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 interests rates or increase the money supply in an attempt to encourage the private market into spending or investing its way out of a downturn.
For instance, the United States’ Federal Reserve has engaged in a dramatic program of quantitative easing since November 2009. However, countries such as Spain, Ireland and Greece do not have the same financial flexibility due to their commitment to the euro. Their only feasible options are reducing spending and raising taxes.