The Effectiveness of Austerity

Research suggests that austerity need not be the only way out for debt incumbent nations

Following the fiscal policy debacles and general macroeconomic turmoil in the US and most of Europe, there has been an on-going debate among policymakers, academics and governing institutions regarding the efficacy of fiscal austerity or stimulus packages to bring economies back to positive growth. On the one hand, advocates of austerity measures argue that debt-laden countries with excessive debt-to-GDP ratios need imperative structural reforms within their economies to ensure stable growth in the future. On the other hand, however, many reason that such measures stifle growth and simply prolong and exacerbate economic sluggishness.

To begin with, it can be argued that as far as Greece and the other debt-ridden EU countries are concerned, austerity seems to be the only viable option to rejuvenate their tattered economies. These countries do not have the monetary independence to manipulate their interest rates and currencies in order to manage their debt. Thus, in theory, they could leave the Eurozone and re-adopt their national currencies.

However, this would most probably lead to a worse scenario due to the overwhelming depreciation of the currencies, in relation to the Euro. For example, this would cause Greek deposits, in the new currency (drachma), to be worth much less than the same deposit held in Euros; this therefore, would be a clear incentive for huge capital flows out of Greece, prior to switching the currency. Along with the resulting speculation, this would lead to bank runs, leaving Greek financial institutions requiring further bailouts.

Additionally, the Greek exit might even lead to other debt incumbent nations (Italy, Spain, Portugal, Ireland) pulling out of the Euro, leaving the macroeconomic situation in Europe even worse. Thus, leaving the Euro is a poor alternative.

Therefore, austerity is the solution for the aforementioned countries because, “The austerians”, as coined by Paul Krugman (an economics professor at Princeton University and columnist for the New York Times), maintain that a major cutback on governmental expenditure is a necessary course of action, which appeases creditors and increases confidence in the markets to facilitate the flow of credit, thereby boosting the economy.

The whole notion of fiscal austerity, however, has been criticized by quite a few prominent economists and academics. Their rationale is that massive cuts in government expenditure, especially to essential public services, leads to a vicious cycle of depressed demand and subsequently higher rates of unemployment. Paul Krugman expresses his disdain for austerians as “People [who] have been taken in by the cult of austerity, by the belief that budget deficits, not mass unemployment, are the clear and present danger, and that deficit reduction will somehow solve a problem brought on by private sector excess”. He also states that countries that have had relative success with austerity measures (such as Ireland and Latvia) have done so by compromising on both employment and output. In other words, these countries have not had an overall (and desirable) recovery due to budget cuts being pursued at the expense of unemployment levels (still the in double-digits for both the aforementioned countries). Moreover, recent research done by the IMF concluded that budget reduction in an already depressed economy may in fact reduce investor confidence due to the latters’ focus on the near-term growth outlook (which is likely to be poor).

In terms of solutions, Krugman gives the example of Japan (under the new Prime Minister Shinzo Abe) as counteracting their debt through means such as quantitative easing and fiscal stimulus packages rather than austerity. Furthermore, Robert H. Frank, economics professor at Cornell University reasons that the fiscal cliff (i.e. austerity measures) faced by the US need not be so steep. He propagates a fiscal stimulus in the form of accelerated short-term infrastructure investment by the government to regain demand, growth and hence employment. He also suggests that an overhaul of the tax system is necessary where demand-depressing taxes such as the payroll and income taxes should be done away with. For this, a more progressive tax system on consumption, carbon emissions and congestion can be phased in gradually. This gradual establishment of taxes would make consumers spend in the near term, (to avoid these taxes in the future), therefore stimulating demand in the economy.

To conclude, the prevailing idea is that rather than impose strict austerity measures with massive budget cuts, governments should focus on bringing the various aspects of the economies back on the path towards positive growth and prosperity. Thus, the real problem is unemployment and poor growth. If these can be fixed, then as by-product of an improved and more robust economy, the debt burden of the various countries can be steadily resolved. As the chief economist of the IMF, Olivier Blanchard puts it, “Decreasing debt is a marathon, not a sprint”, “Going too fast will kill growth.”