Does Austerity Work?

2324 words (9 pages) Essay in Economics

25/07/17 Economics Reference this

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Critically evaluate claims that austerity is the most effective strategy to counter a recession.

Austerity is one of the most controversial economic policies, not only because there is an ongoing debate between academics and policy makers about its effectiveness and consequences, but also because it effects the life of millions and have caused many political and social turmoil when implemented. The advocate of this policy argues that it is the most effective and even more; it is the solution regardless of the structure of the economy and the cause of the economic downturn or recession. I will argue that this is not true, and that there are other policy designs that proved effective and delivered good results with less social cost in term of unemployment, social disturbances and welfare reduction.

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Austerity measures were recommended by policy makers in advanced economies as well as international organizations such as the IMF and the Word Bank. They were prescribed as a remedy in many economics situations and contexts in the developing countries, for example: Latin America sovereign debt crisis and the Asian crisis, furthermore in the aftermath of the financial crisis of 2007 and the great rescission that followed austerity policies were implemented or advocated in developed economies like UK, USA and part of the debt troubled EU countries referred to as PIGS (Portugal, Ireland, Greece and Spain) (Blyth, 2013).

But it is important to first define what is meant by austerity and what is the underlying economic theory behind it. Usually when economists or policy makers refer to austerity they generally mean the reduction in the structural deficit in the government budget regardless of its effect on the business cycle, and it is also refers to the policy of reducing the size of the public sector in general (Room, 2015). This can be done through lowering the government expenditure (like social and welfare benefits, spending on infrastructure and healthcare, lowering wages, etc.). The underlying economic reasoning behind austerity policy is that high level of public debt is a burden on the future generations because any debt should be paid in the future from budget surpluses raised form tax payers. It also cause higher level of interest rate (due to higher demand by government) which in turn discourage private investment. Accordingly austerity policy by reducing the government expenditure will reduce the public debt, consequently increase confidence in the economy, reduce interest rates and consequently stimulate private investment spending and the economy. A common theme in austerity policy is the believe that government intervention itself through fiscal policy is the source of economic imbalances and it associate crisis with bad public finance management and reckless spending behavior (Wren-Lewis, 2016).

The advocate of austerity say that the national economy cannot grow out of debt. Some scholars argue that if the ratio of debt to gross domestic product (GDP) is reach 90% for advanced economies, or 60% for emerging economies, the debt will slow down economic growth (Reinhart and Rogoff, 2010). In this situation, the economy can easily experience financial crises because the investor confidence will fall, and this will make foreign direct investment become less (Konzelmann, 2014; Reinhart and Rogoff, 2010). Another connected idea is that high level of debt means that the government needs to take capital resources from the community to pay for it, and this will also slow the growth of the economy. The national economies with high debt therefore likely to raise interest rates to encourage demand for government bonds, and this will make it more expensive for the public to borrow money. The result of this expense is low consumption and growth, so the economy will steadily decline (Boccia, 2013). The high interest rates also make the currency become more valuable, which means that exports slow down because they become more expensive for international market, and this will also slow down the economy (Patillo et al., 2002). The advocate of austerity therefore argue that high levels of debt will cause the economy to slow down, and say that cutting debt, which austerity does, is the best way to help countries with high debt to achieve growth (Blyth, 2013).

There are ample of evidence contradicting the argument that the austerity is always a solution to recession. An analysis of the performance and consequences of such policies suggest that austerity policy in practice led in many instances to worsening the recession and budget deficit mainly due to its blind application and its tendency to ignore the different economic structure for each country, in fact it worsen the symptoms that it designed to cure (Haltom and Lubik, 2013). Let’s look at the experience of Spain with austerity. Before the 2007 financial crisis Spain had enjoyed robust economy with long period of growth led by the real estate sector, the budget was actually in surplus at around 2.5% of the GDP. When the crisis of 2007 hit Spain economic vulnerabilities; mainly uncompetitive private sector and the over reliance on real estate sector and excessive borrowing by the private sector. The crisis resulted in lower demand and hence lower tax collection and budget deficit. Furthermore deterioration in bank assets quality and solvency problem surfaced (Dellepiane and Hardiman, 2012).

In 2010 Spain like many other troubled EU countries implemented the austerity formula i.e. cut spending. This solution was based on misinterpretation of the crisis cause in Spain (and southern Europe in general) that the crisis is caused by the mismanaged public finances, so not surprisingly was the result, instead of the “expansionary austerity” Spain got stuck of a vicious circle of lower demand (driven by lower government spending), lower tax collection (revenues), higher unemployment and further deterioration of the financial sector health (Dellepiane and Hardiman, 2012). In fact this was the situation of all the EU countries that implemented austerities, as we can show from the economic performance of Portugal, Italy, Ireland, Greece and Spain (PIIGS) since 2008. For all these countries, austerity made their debt increase, not decline, and economic activity slowed down (Blyth, 2013). In Greece, the ration of debt to GDP grew from 106% to 170% from 2007 to 2012, even though there was much austerity cuts. The same case happened on Portugal, Italy, Ireland and Spain.

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The economist Paul Krugman pointed out that the idea of austerity collapsed under the empirical results of the policy of austerity, and he refers to the academic and research body that supported austerity did not stand scrutiny and turned out to be based on dubious statistical methods and sometimes outright mistakes (Krugman, 2015). In similar way, Simon Wren-Lewis (2016) observed that the austerity in Europe was unnecessary outcome of the fiscal contraction. In other words, the European countries could have successfully run a gradual fiscal consolidation accompanied with expansionary monetary policy by the ECB to offset the contractionary effect of the fiscal policy. However in case of Europe in 2010 the interest rates was already at zero and there was no room for expansionary monetary policy (a situation also referred to as liquidity trap), so postponing fiscal consolidation would not just delay austerity but avoid it all together (Wren-Lewis, 2016).

It is therefore very clear that austerity cannot be a solution for recessions, but the question is then what can be the cure. If we go back in the recent history of the economic theory and policy we can establish that there have been examples of an alternative economic policy to austerity that has successfully dealt with recessions and restored the economic activity to the growth path. This policy was the Keynesian economic that prevailed for a period of 30 years from the world war II till late 1970’s. Keynes model of how the economy works are based on the idea that when there is economic downturn and since business expectation in the recession are low because of the uncertainty only the government has can restore confidence to the economy and the policy recommendation is to increase government spending (expansionary fiscal policy) to boost he general level of economic activity, increase demand and compensate for the lower private demand (Burton, 2016). This is the very opposite of the idea of austerity, and many economists now argue the same thing.

Paul Krugman (2012) is a famous example of this argument. Krugman rejects the idea of austerity, and argues that to help the economy come out of the recession it is necessary for the government to increase debt. The foundation of this argument is the nature of debt. Krugman (2012) says that the economist must consider public debt and private debt as two separate things, rather than just the same. His reason for this idea is that, first, private debt needs to be recompensed, but this is not the issue with government debt. For the governments, it is just necessary to make sure that there is enough tax to cover debts. Another difference is that in private debt the money is owed to someone else, but government debt is money that the government owes to itself and to the country, such as pensions and other requirements (Krugman 2012). If these differences are considered, it becomes clear that in a situation of high personal debt, a good solution is for the government to take on higher debt to help boost the economic activity (Krugman and Eggertsson, 2012). Krugman and Eggertsson (2012) argue that fiscal expenditure must be used to maintain employment, productivity and earnings at the time that private debt is decreased, because this will keep the tax earnings up and permit the government to decrease its own debt when the recession is over. Beside, increased financial expansion will work better in a situation where interest rates are lower, because there will be lower ‘crowding out’ of private business (Krugman and Eggertsson, 2012: 1490). In such situations, financial stimulus will therefore boost economic activity and give good growth to GDP, while decreases in public spending will have the opposite effect, slowing growth and bringing GDP down (Holland and Portes, 2012).

In this essay, I have shown the foundation of the idea of austerity and explained why the economists who believe it say that it is the solution for the situation of a recession. The advocate of austerity argues that high public debt makes it more expensive to obtain a loan, and this causes the economy to slow. Furthermore, it also causes currency inflation, which causes exports to become more expensive and slows economic activity. FDI also slows down, and all these factors together mean that the economy cannot achieve any development. The solution of austerity is therefore to cut public spending to bring down the public debt. However, the empirical evidence of the effects of austerity measures show that it is not a useful policy to achieve these ends. In countries such as Greece, Spain and others where austerity has been used, austerity has caused the opposite of these results: ratio of debt to GDP gets higher and higher, unemployment rises, economic growth slows, and the recession becomes worse. The reason for this fail of austerity to solve the problem is because the advocate of austerity does not differentiate between public debt and private debt, as Krugman (2012) argues. In the recession, if the government takes on more debt through implementing fiscal stimulus, it can stimulate economic activity by allowing people to spend and take loans. This will increase the circulation of capital, which will have many positive effects in bringing about growth. Then, when the private debt level is high and the economy is more active, the government can reduce its financial stimulus to bring down its debt. In both theoretically and empirically, it is clear that austerity cannot solve the problems that cause recession, and it therefore necessary to consider the alternatives.

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