What is Austerity?

Austerity is like trying to balance your household budget…

Just as austerity in the personal realm might mean cutting back on non-essential purchases and trying to save more money, governments have to do the same thing when they get overextended financially.

Austerity is an economic policy where governments work to reduce public debt. Commonly, governments accomplish this goal by raising taxes and/or reducing public spending on things like infrastructure, defense, salaries, and benefits.

Governments tend to use austerity policies when they worry about the size of the public debt and the potential for default. Just like individuals and businesses, governments must borrow money if they don’t take in enough money to cover their expenses.

Governments that are at high risk of not paying their debts have to pay higher interest rates than those with more stable finances — This can quickly cause governments to spiral into unsustainable debt. Austerity attempts to rein in the government’s debt before it becomes unmanageable.

Austerity occurs when governments reduce the difference between their income and expenditures (when expenditures are more than income). Governments have two main strategies to accomplish this.

The first strategy involves raising taxes,. Increasing the government’s income can reduce its deficit.

The second strategy is reducing spending — sometimes in concert with a tax hike. This has the advantage of reducing the deficit from both directions: income and expenses. Typically, the spending cuts come from non-essential government functions. This strategy is popular with German Chancellor Angela Merkel, who encouraged European countries to cut spending in the wake of the 2008 recession.

Each of these strategies has benefits and drawbacks, and they do not always work as well in practice as they do in theory. This means it’s important for governments to assess their current situation when considering austerity policies.

Whether austerity is good for the economy is a hotly debated topic, and the answer largely seems to vary based on the economic theories that the answerer follows. Some economists feel that the correct response to economic contraction is to increase public spending (thereby increasing public debt) to stimulate growth. Others believe that recession necessitates reduced government spending as increased debt has significant, negative long-term consequences.

One real-world example of an austerity policy comes from Greece in the wake of the 2008 recession. As part of a bailout agreement with the EU, Greece raised taxes and reduced government spending on all non-essential projects. It removed tax loopholes that allowed businesses to make large deductions, cut government employment, and sold public property, such as state-owned buildings to private citizens.

During the same time period, Spain implemented policies that reduced spending and raised taxes on many products, such as tobacco.

A historical example is Warren G. Harding’s reaction to a 1920 recession in the United States. Harding cut government spending by almost 50% and reduced tax rates for all income brackets, reducing the national debt by as much as a third. Within three years, the unemployment rate dropped from a high of almost 12% to 2.4%.

The goal of austerity is to reduce the government’s spending deficit and help it repay its debts. Taxes — such as income taxes, tariffs, Value-Added Taxes, and property taxes — are the primary ways that governments produce income. Income is half of the budgeting equation, with expenses serving as the other half.

Increasing tax receipts, either by increasing tax rates or reducing non-payment of taxes, gives the government more income to use. Assuming that it does not increase its expenses, the government can reduce the deficit with increased tax income.

Government spending is the other half of the equation when it comes to reducing budget deficits. The less money that the government spends on things like wages, infrastructure projects, defense, and public programs, the less money the government needs to make to balance its books.

If the government holds tax income steady, it can still reduce its debt by reducing its spending. If taxes fall, spending has to fall to compensate for the lost income. If taxes increase, the government can increase spending without making the deficit any worse. Increasing spending by a smaller amount than the increase in tax income also reduces the deficit.

Whether austerity is an effective strategy for reducing government deficits is widely debated by economists. Many believe that the proper reaction to an economic recession is increased government spending with the goal of stimulating the economy.

The belief is that public spending leads to greater employment, which increases tax revenues, making increased spending have minimal effect on the government’s deficit in the long-run. This belief is popular amongst Keynesian economists, who believe the theories of John Maynard Keynes.

To Keynesians, the risk of austerity is that reduced government spending will cause further harm to the economy, increasing unemployment, which in turn reduces tax revenues. As tax revenues fall, the proper response under austerity policies would be to further reduce spending, leading to a self-reinforcing cycle of declining government spending and a worsening economy.

One of the structural issues related to austerity is that it is limited to the government’s actions, so the government sees most of the benefits of austerity policies.

Greece is a recent example of this. Interest rates on Greek bonds fell as the government began austerity. That meant that the government did not have to spend as much money paying interest on its debts. However, reduced interest rates on government bonds did not extend to the private market. Large businesses took advantage of lower rates, but private consumers did not see most of the effects of lower rates, making it difficult for the economy to grow.

Greece also lacked strong exports. As a country’s currency becomes weaker in comparison to other currencies, its exports should grow as its goods become cheaper in other nations. Austerity policies often reduce the value of the national currency, meaning they help grow exports. Because Greece did not have a significant export industry, it wasn’t able to take advantage of this benefit.

Another potential structural issue related to austerity is the effect on major employers in a country –- Especially if the government employs a large percentage of the populace, such as in the United States. In the U.S., local, state, and federal governments employ as much as a quarter of the workforce in some states.

If austerity policies involve reductions in government spending, it can lead to hiring freezes or layoffs. If the government eliminates a significant portion of its workforce, it can cause high levels of unemployment in an economy — Especially where private businesses aren’t equipped to employ people in the numbers required to produce growth, even outside of recessionary conditions.