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What is 'Austerity'

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.

BREAKING DOWN 'Austerity'

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 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)

Historical 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."

What Are the Risks of Austerity Measures?

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 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. 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 Progression Following 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 a 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. 

 

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