Austerity

In October 2012, the IMF announced that its forecasts for countries that implemented austerity programs have been consistently overoptimistic, suggesting that tax hikes and spending cuts have been doing more damage than expected and that countries that implemented fiscal stimulus, such as Germany and Austria, did better than expected.[24]

The IMF reported that this was due to fiscal multipliers that were considerably larger than expected: for example, the IMF estimated that fiscal multipliers based on data from 28 countries ranged between 0.9 and 1.7. In other words, a 1% GDP fiscal consolidation (i.e., austerity) would reduce GDP between 0.9% and 1.7%, thus inflicting far more economic damage than the 0.5 previously estimated in IMF forecasts.[25]

In many countries, little is known about the size of multipliers, as data availability limits the scope for empirical research.

For these countries, Nicoletta Batini, Luc Eyraud and Anke Weber propose a simple method—dubbed the "bucket approach"—to come up with reasonable multiplier estimates. The approach bunches countries into groups (or "buckets") with similar multiplier values, based on their characteristics, and taking into account the effect of (some) temporary factors such as the state of the business cycle.

Different tax and spending choices of equal magnitude have different economic effects:[26][27][28]

For example, the U.S. Congressional Budget Office estimated that the payroll tax (levied on all wage earners) has a higher multiplier (impact on GDP) than does the income tax (which is levied primarily on wealthier workers).[29] In other words, raising the payroll tax by $1 as part of an austerity strategy would slow the economy more than would raising the income tax by $1, resulting in less net deficit reduction.

In theory, it would stimulate the economy and reduce the deficit if the payroll tax were lowered and the income tax raised in equal amounts.[30]

The term "crowding out" refers to the extent to which an increase in the budget deficit offsets spending in the private sector. Economist Laura Tyson wrote in June 2012, "By itself an increase in the deficit, either in the form of an increase in government spending or a reduction in taxes, causes an increase in demand". How this affects output, employment, and growth depends on what happens to interest rates:

When the economy is operating near capacity, government borrowing to finance an increase in the deficit causes interest rates to rise and higher interest rates reduce or "crowd out" private investment, reducing growth. This theory explains why large and sustained government deficits take a toll on growth: they reduce capital formation. But this argument rests on how government deficits affect interest rates, and the relationship between government deficits and interest rates varies.

When there is considerable excess capacity, an increase in government borrowing to finance an increase in the deficit does not lead to higher interest rates and does not crowd out private investment. Instead, the higher demand resulting from the increase in the deficit bolsters employment and output directly. The resultant increase in income and economic activity in turn encourages, or "crowds in", additional private spending.

Some argue that the "crowding-in" model is an appropriate solution for current economic conditions.[9]

Sectoral balances in U.S. economy 1990–2012. By definition, the three balances must net to zero. Since 2009, the U.S. capital surplus and private-sector surplus have driven a government budget deficit.

According to economist Martin Wolf, the U.S. and many Eurozone countries experienced rapid increases in their budget deficits in the wake of the 2008 crisis as a result of significant private-sector retrenchment and ongoing capital account surpluses.

Policy choices had little to do with these deficit increases. This makes austerity measures counterproductive. Wolf explained that government fiscal balance is one of three major financial sectoral balances in a country's economy, along with the foreign financial sector (capital account) and the private financial sector.

By definition, the sum of the surpluses or deficits across these three sectors must be zero. In the U.S. and many Eurozone countries other than Germany, a foreign financial surplus exists because capital is imported (net) to fund the trade deficit. Further, there is a private-sector financial surplus because household savings exceed business investment.

By definition, a government budget deficit must exist so all three net to zero: for example, the U.S. government budget deficit in 2011 was approximately 10% of GDP (8.6% of GDP of which was federal), offsetting a foreign financial surplus of 4% of GDP and a private-sector surplus of 6% of GDP.[31]

Wolf explained in July 2012 that the sudden shift in the private sector from deficit to surplus forced the U.S. government balance into deficit: "The financial balance of the private sector shifted towards surplus by the almost unbelievable cumulative total of 11.2 per cent of gross domestic product between the third quarter of 2007 and the second quarter of 2009, which was when the financial deficit of US government (federal and state) reached its peak.... No fiscal policy changes explain the collapse into massive fiscal deficit between 2007 and 2009, because there was none of any importance. The collapse is explained by the massive shift of the private sector from financial deficit into surplus or, in other words, from boom to bust."[31]

Wolf also wrote that several European economies face the same scenario and that a lack of deficit spending would likely have resulted in a depression. He argued that a private-sector depression (represented by the private- and foreign-sector surpluses) was being "contained" by government deficit spending.[32]

Economist Paul Krugman also explained in December 2011 the causes of the sizable shift from private-sector deficit to surplus in the U.S.: "This huge move into surplus reflects the end of the housing bubble, a sharp rise in household saving, and a slump in business investment due to lack of customers."[33]

One reason why austerity can be counterproductive in a downturn is due to a significant private-sector financial surplus, in which consumer savings is not fully invested by businesses. In a healthy economy, private-sector savings placed into the banking system by consumers are borrowed and invested by companies. However, if consumers have increased their savings but companies are not investing the money, a surplus develops.

Business investment is one of the major components of GDP. For example, a U.S. private-sector financial deficit from 2004 to 2008 transitioned to a large surplus of savings over investment that exceeded $1 trillion by early 2009, and remained above $800 billion into September 2012. Part of this investment reduction was related to the housing market, a major component of investment. This surplus explains how even significant government deficit spending would not increase interest rates (because businesses still have access to ample savings if they choose to borrow and invest it, so interest rates are not bid upward) and how Federal Reserve action to increase the money supply does not result in inflation (because the economy is awash with savings with no place to go).[33]

Economist Richard Koo described similar effects for several of the developed world economies in December 2011: "Today private sectors in the U.S., the U.K., Spain, and Ireland (but not Greece) are undergoing massive deleveraging [paying down debt rather than spending] in spite of record low interest rates. This means these countries are all in serious balance sheet recessions. The private sectors in Japan and Germany are not borrowing, either. With borrowers disappearing and banks reluctant to lend, it is no wonder that, after nearly three years of record low interest rates and massive liquidity injections, industrial economies are still doing so poorly. Flow of funds data for the U.S. show a massive shift away from borrowing to savings by the private sector since the housing bubble burst in 2007. The shift for the private sector as a whole represents over 9 percent of U.S. GDP at a time of zero interest rates. Moreover, this increase in private sector savings exceeds the increase in government borrowings (5.8 percent of GDP), which suggests that the government is not doing enough to offset private sector deleveraging."[34]

Public Debt to GDP Ratio for Selected European Countries – 2008 to 2012. Source Data: Eurostat

A typical goal of austerity is to reduce the annual budget deficit without sacrificing growth. Over time, this may reduce the overall debt burden, often measured as the ratio of public debt to GDP.[40]

Relationship between fiscal tightening (austerity) in Eurozone countries with their GDP growth rate, 2008–12[41]

During the European debt crisis, many countries embarked on austerity programs, reducing their budget deficits relative to GDP from 2010 to 2011.

According to the CIA World Factbook, Greece decreased its budget deficit from 10.4% of GDP in 2010 to 9.6% in 2011. Iceland, Italy, Ireland, Portugal, France, and Spain also decreased their budget deficits from 2010 to 2011 relative to GDP[42][43] but the austerity policy of the Eurozone achieves not only the reduction of budget deficits. The goal of economic consolidation influences the future development of the European Social Model.

With the exception of Germany, each of these countries had public-debt-to-GDP ratios that increased from 2010 to 2011, as indicated in the chart at right. Greece's public-debt-to-GDP ratio increased from 143% in 2010 to 165% in 2011[43] Indicating despite declining budget deficits GDP growth was not sufficient to support a decline in the debt-to-GDP ratio for these countries during this period.

Eurostat reported that the overall debt-to-GDP ratio for the EA17 was 70.1% in 2008, 80.0% in 2009, 85.4% in 2010, 87.3% in 2011, and 90.6% in 2012.[42][44][45] Further, real GDP in the EA17 declined for six straight quarters from Q4 2011 to Q1 2013.[46]

Unemployment is another variable considered in evaluating austerity measures. According to the CIA World Factbook, from 2010 to 2011, the unemployment rates in Spain, Greece, Ireland, Portugal, and the UK increased. France and Italy had no significant changes, while in Germany and Iceland the unemployment rate declined.[43] Eurostat reported that Eurozone unemployment reached record levels in March 2013 at 12.1%,[47] up from 11.6% in September 2012 and 10.3% in 2011. Unemployment varied significantly by country.[48]

Economist Martin Wolf analyzed the relationship between cumulative GDP growth in 2008 to 2012 and total reduction in budget deficits due to austerity policies in several European countries during April 2012 (see chart at right). He concluded, "In all, there is no evidence here that large fiscal contractions budget deficit reductions bring benefits to confidence and growth that offset the direct effects of the contractions. They bring exactly what one would expect: small contractions bring recessions and big contractions bring depressions."

Changes in budget balances (deficits or surpluses) explained approximately 53% of the change in GDP, according to the equation derived from the IMF data used in his analysis.[49]

Similarly, economist Paul Krugman analyzed the relationship between GDP and reduction in budget deficits for several European countries in April 2012 and concluded that austerity was slowing growth. He wrote: "this also implies that 1 euro of austerity yields only about 0.4 euros of reduced deficit, even in the short run. No wonder, then, that the whole austerity enterprise is spiraling into disaster."[50]

The Greek government-debt crisis brought a package of austerity measures, put forth by the EU and the IMF mostly in the context of the three successive bailouts the country endured from 2010 to 2018; it was met with great anger by the Greek public, leading to riots and social unrest.[51] On 27 June 2011, trade union organizations began a 48-hour labour strike in advance of a parliamentary vote on the austerity package, the first such strike since 1974.[52]

Massive demonstrations were organized throughout Greece, intended to pressure members of parliament into voting against the package.[53] The second set of austerity measures was approved on 29 June 2011, with 155 out of 300 members of parliament voting in favor.[54] However, one United Nations official warned that the second package of austerity measures in Greece could pose a violation of human rights.[55]

Around 2011, the IMF started issuing guidance suggesting that austerity could be harmful when applied without regard to an economy's underlying fundamentals.[56]

In 2013, it published a detailed analysis concluding that "if financial markets focus on the short-term behavior of the debt ratio, or if country authorities engage in repeated rounds of tightening in an effort to get the debt ratio to converge to the official target", austerity policies could slow or reverse economic growth and inhibit full employment.[57] Keynesian economists and commentators such as Paul Krugman have suggested that this has in fact been occurring, with austerity yielding worse results in proportion to the extent to which it has been imposed.[58][59]

Overall, Greece lost 25% of its GDP during the crisis. Although the government debt increased only 6% between 2009 and 2017 (from €300 bn to €318 bn) — thanks, in part, to the 2012 debt restructuring —,[60][61] the critical debt-to-GDP ratio shot up from 127% to 179%[60] mostly due to the severe GDP drop during the handling of the crisis. In all, the Greek economy suffered the longest recession of any advanced capitalist economy to date, overtaking the US Great Depression. As such, the crisis adversely affected the populace as the series of sudden reforms and austerity measures led to impoverishment and loss of income and property, as well as a small-scale humanitarian crisis.[62][63][64] Unemployment shot up from 8% in 2008 to 27% in 2013 and remained at 22% in 2017.[65] As a result of the crisis, Greek political system has been upended, social exclusion increased, and hundreds of thousands of well-educated Greeks left the country.[66][67]

In April and May 2012, France held a presidential election in which the winner, François Hollande, had opposed austerity measures, promising to eliminate France's budget deficit by 2017 by canceling recently enacted tax cuts and exemptions for the wealthy, raising the top tax bracket rate to 75% on incomes over one million euros, restoring the retirement age to 60 with a full pension for those who have worked 42 years, restoring 60,000 jobs recently cut from public education, regulating rent increases, and building additional public housing for the poor. In the legislative elections in June, Hollande's Socialist Party won a supermajority capable of amending the French Constitution and enabling the immediate enactment of the promised reforms. Interest rates on French government bonds fell by 30% to record lows,[68] fewer than 50 basis points above German government bond rates.[69]

Latvia's economy returned to growth in 2011 and 2012, outpacing the 27 nations in the EU, while implementing significant austerity measures. Advocates of austerity argue that Latvia represents an empirical example of the benefits of austerity, while critics argue that austerity created unnecessary hardship with the output in 2013 still below the pre-crisis level.[70][71] While Anders Åslund maintains[72] that internal devaluation was not opposed by the Latvian public, Jokubas Salyga has recently chronicled[73] widespread protests against austerity in the country.

According to the CIA World Fact Book, "Latvia's economy experienced GDP growth of more than 10% per year during 2006–07, but entered a severe recession in 2008 as a result of an unsustainable current account deficit and large debt exposure amid the softening world economy. Triggered by the collapse of the second largest bank, GDP plunged 18% in 2009. The economy has not returned to pre-crisis levels despite strong growth, especially in the export sector in 2011–12. The IMF, EU, and other international donors provided substantial financial assistance to Latvia as part of an agreement to defend the currency's peg to the euro in exchange for the government's commitment to stringent austerity measures.

The IMF/EU program successfully concluded in December 2011. The government of Prime Minister Valdis Dombrovskis remained committed to fiscal prudence and reducing the fiscal deficit from 7.7% of GDP in 2010, to 2.7% of GDP in 2012." The CIA estimated that Latvia's GDP declined by 0.3% in 2010, then grew by 5.5% in 2011 and 4.5% in 2012. Unemployment was 12.8% in 2011 and rose to 14.3% in 2012. Latvia's currency, the Lati, fell from $0.47 per U.S. dollar in 2008 to $0.55 in 2012, a decline of 17%. Latvia entered the euro zone in 2014.[74] Latvia's trade deficit improved from over 20% of GDP in 2006 to 2007[75] to under 2% GDP by 2012.[74]

Eighteen months after harsh austerity measures were enacted (including both spending cuts and tax increases),[75] economic growth began to return, although unemployment remained above pre-crisis levels. Latvian exports have skyrocketed and both the trade deficit and budget deficit have decreased dramatically. More than one-third of government positions were eliminated, and the rest received sharp pay cuts. Exports increased after goods prices were reduced due to private business lowering wages in tandem with the government.[70][76]

Paul Krugman wrote in January 2013 that Latvia had yet to regain its pre-crisis level of employment. He also wrote, "So we're looking at a Depression-level slump, and 5 years later only a partial bounceback; unemployment is down but still very high, and the decline has a lot to do with emigration. It's not what you'd call a triumphant success story, any more than the partial US recovery from 1933 to 1936—which was actually considerably more impressive—represented a huge victory over the Depression. And it's in no sense a refutation of Keynesianism, either. Even in Keynesian models, a small open economy can, in the long run, restore full employment through deflation and internal devaluation; the point, however, is that it involves many years of suffering".[77]

Latvian Prime Minister Valdis Dombrovskis defended his policies in a television interview, stating that Krugman refused to admit his error in predicting that Latvia's austerity policy would fail.[78] Krugman had written a blog post in December 2008 entitled "Why Latvia is the New Argentina", in which he argued for Latvia to devalue its currency as an alternative or in addition to austerity.[79]

Following the Second World War the United Kingdom had huge debts, large commitments, and had sold many income producing assets. Rationing of food and other goods which had started in the war continued for some years.

Following the financial crisis of 2007–2008 a period of economic recession began in the UK. The austerity programme was initiated in 2010 by the Conservative and Liberal Democrat coalition government, despite some opposition from the academic community.[80] In his June 2010 budget speech, the Chancellor George Osborne identified two goals. The first was that the structural current budget deficit would be eliminated to "achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period". The second was that national debt as a percentage of GDP would fall. The government intended to achieve both of its goals through substantial reductions in public expenditure. This was to be achieved by a combination of public spending reductions and tax increases. Economists Alberto Alesina, Carlo A. Favero and Francesco Giavazzi, writing in Finance & Development in 2018, argued that deficit reduction policies based on spending cuts typically have almost no effect on output, and hence form a better route to achieving a reduction in the debt-to-GDP ratio than raising taxes. The authors commented that the UK government austerity programme had resulted in growth that was higher than the European average and that the UK's economic performance had been much stronger than the International Monetary Fund had predicted.[81] This claim was challenged most strongly by Mark Blyth, whose 2014 book on austerity claims that austerity not only fails to stimulate growth, but effectively passes that debt down to the working classes.[82] As such, many academics such as Andrew Gamble view Austerity in Britain less as an economic necessity, and more as a tool of statecraft, driven by ideology and not economic requirements.[83] A study published in The BMJ in November 2017 found the Conservative government austerity programme had been linked to approximately 120,000 deaths since 2010; however, this was disputed, for example on the grounds that it was an observational study which did not show cause and effect.[84][85] More studies claim adverse effects of austerity on population health, which include an increase in the mortality rate among pensioners which has been linked to unprecedented reductions in income support,[86] an increase in suicides and the prescription of antidepressants for patients with mental health issues,[87] and an increase in violence, self-harm, and suicide in prisons.[88][89]

The United States' response to the 2008 economic crash was largely influenced by Wall Street and IMF interests, who favored fiscal retrenchment in the face of the economic crash. Evidence exists to suggest that Pete Peterson (and the Petersonites) have heavily influenced US policy on economic recovery since the Nixon era,[90] and presented itself in 2008, despite austerity measures being "wildly out of step with public opinion and reputable economic policy...[and showing] anti-Keynesian bias of supply-side economics and a political system skewed to favor Wall Street over Main Street".[91] The nuance of the economic logic of Keynesianism is, however, difficult to put across to the American Public, and compares poorly to the simplistic message which blames government spending, which might explain Obama's preferred position of a halfway point between economic stimulus followed by austerity, which led to him being criticized by economists such as Stiglitz.[92]

J. Bradford DeLong and Lawrence Summers explained why an expansionary fiscal policy is effective in reducing a government's future debt burden, pointing out that the policy has a positive impact on its future productivity level.[155] They pointed out that when an economy is depressed and its nominal interest rate is near zero, the real interest rate charged to firms ${\displaystyle r^{f}}$ is linked to the output as ${\displaystyle {\frac {\partial r^{f}}{\partial Y}}=-\delta }$. This means that the rate decreases as the real GDP increases, and the actual fiscal multiplier ${\displaystyle \mu }$ is higher than that in normal times; a fiscal stimulus is more effective for the case where the interest rates are at the zero bound. As the economy is boosted by government spending, the increased output yields higher tax revenue, and so we have

${\displaystyle {\frac {\partial D}{\partial G}}=1-\mu \tau \;,}$

where ${\displaystyle \tau }$ is a baseline marginal tax-and-transfer rate. Also, we need to take account of the economy's long-run growth rate ${\displaystyle g}$, as a steady economic growth rate may reduce its debt-to-GDP ratio. Then we can see that an expansionary fiscal policy is self-financing:[155]

${\displaystyle (r-g)dD-\tau dY=(r-g)(1-\mu \tau )dG-\tau \eta \mu dG}$

${\displaystyle {\frac {\partial B}{\partial G}}=(r-g)(1-\mu \tau )-\tau \eta \mu \;,}$

as long as ${\displaystyle {\frac {\partial B}{\partial G}}}$ is less than zero. Then we can find that a fiscal stimulus makes the long-term budget in surplus if the real government borrowing rate satisfies the following condition:[155]

${\displaystyle (r-g)(1-\mu \tau )<\tau \eta \mu }$

Research by Gauti Eggertsson et al. indicates that a government's fiscal austerity measures actually increase its short-term budget deficit if the nominal interest rate is very low.[156] In normal time, the government sets the tax rates ${\displaystyle \tau _{s},\tau _{i}}$ and the central bank controls the nominal interest rate ${\displaystyle i}$. If the rate is so low that monetary policies cannot mitigate the negative impact of the austerity measures, the significant decrease of tax base makes the revenue of the government and the budget position worse.[157] If the multiplier is

${\displaystyle {\frac {\partial Y}{\partial G}}>\gamma ={\frac {1+\tau _{s}+\theta \sigma ^{-1}\psi }{\tau _{i}+\tau _{s}+\theta }}}$

then we have ${\displaystyle {\frac {\partial D}{\partial G}}<0\;}$, where

${\displaystyle \theta ={\frac {b}{Y}}(1+i){\frac {\kappa }{(1-\beta \mu )}}\;.}$

That is, the austerity measures are counterproductive in the short-run, as long as the multiplier is larger than a certain level ${\displaystyle \gamma }$. This erosion of the tax base is the effect of the endogenous component of the deficit.[157] Therefore, if the government increases sales taxes, then it reduces the tax base due to its negative effect on the demand, and it upsets the budget balance.

For a country that has its own currency, its government can create credits by itself, and its central bank can keep the interest rate close to or equal to the nominal risk-free rate. Former FRB chairman Alan Greenspan says that the probability that the US defaults on its debt repayment is zero, because the US government can print money.[158] The FRB of St. Louis says that the US government's debt is denominated in US dollars; therefore the government will never go bankrupt, though it may introduce the risk of inflation.[158]