What’s it: Austerity policy is an action by the government to reduce government debt. The government usually adopts it when debt is too high, hence weighing economic performance.
High debt tends to be out of control. It is dangerous and causes financial instability in the economy.
Debt piles up because the government runs a continuous fiscal deficit. At the same time, tax revenue growth is lower than government spending. That resulted in an even higher deficit. To cover it, the government must take debt, for example, by issuing bonds.
High debt increases the risk of default. To compensate for the risk, investors demand higher interest. As a result, it is difficult for the interest rate to fall in an economy when debt is high.
High-interest rates are weighing on economic growth. It hurts household consumption and business investment.
To save and reduce the debt burden, the government cuts its spending, even when growth is weak. Cutting budgets when the economy is weak raises other problems. Growth will fall further, and unemployment soars.
Austerity policy objectives
The main objective of austerity policies is to reduce debt by cutting the fiscal deficit. Basically, the debt outstanding today is the accumulated budget deficit over the previous years.
High debt increases the risk of default—the government’s ability to pay interest or principal on loans decreases. A higher default risk increases the premium demanded by lenders.
The lender demands a higher premium and interest rate to compensate for the higher risk. As a result, it caused interest expenses to soar. If the value exceeds the additional tax income, the debt burden becomes out of control.
In such situations, lenders usually force the government to exercise fiscal discipline. The government must take austerity measures to reduce the deficit. The government then cut its spending items, increasing taxes, or a combination of both.
How the austerity policy works
Government budgeting is unlike corporate budgeting. Companies have two sources of capital: debt and equity. To reduce debt and reduce the default risk, they can raise equity capital.
In contrast, the government has no equity capital. Therefore, the primary option for reducing debt is to reduce the deficit. In this case, the government should cut spending, raise taxes, or both.
Reducing the deficit is the right way to reduce the risk of default and improve the sovereign rating. It requires fiscal discipline and a strong commitment to succeed, even amid public pressure.
A decrease in the deficit increases the confidence of lending institutions such as the IMF.
However, austerity measures are also unpopular. As advocated by the IMF, strict fiscal discipline requires governments to reduce spending and raise taxes, even when the economy is weak. Increased taxes and decreased spending weaken aggregate demand. As a result, economic growth falls, and the unemployment rate increases.
Even though the government is still pursuing a fiscal deficit policy, austerity reduces its value. The result is that the need for financing through debt decreases.
A more significant step is to move from deficit to fiscal surplus. The government suppresses spending so that it doesn’t exceed revenue. Then, the government can use the surplus revenue to pay off debt.
Some countries prefer to combine a tax increase with a disproportionate increase in spending. The additional tax revenue is higher than the increase in spending. The aim of the increase in spending is to stimulate growth so the government can collect higher taxes. For example, suppose that tax revenue increases by $300 and expenses by about $100. On a net basis, the deficit decreases by $200 ($300-$100).
In general, reducing the fiscal deficit can take several alternatives, including:
- Raise taxes at a higher percentage than the increase in government spending.
- Raise taxes and keep government spending unchanged.
- Raise taxes and decrease spending.
- Keep taxes revenue unchanged, but the government cuts spending.
- Reduce taxes but at a lower rate than cuts in spending.
Economists usually prefer the latter option. Taxes have far-reaching implications for the economy, particularly on household consumption and business investment decisions. As a result, lowering taxes result in less intervention in market equilibrium.
Example of austerity policies
During the Eurozone debt crisis, several European countries, such as Britain, Greece, and Spain, implemented austerity measures to reduce budget problems.
In the UK, policy targets drastic reductions in public spending and tax increases. The government cut direct spending by more than £30 billion between 2010 and 2019. The main targets of the cuts were welfare payments, housing subsidies, and social services.
The debt crisis forced the Greek government to implement austerity programs proposed by the European Union, European Central Bank, and IMF. The Greek parliament approved a €13.5 billion austerity package in November 2012, stemming from spending cuts and tax increases.
Spain in 2012 also announced budget savings from a tax increase of €12.3 billion and a decrease in the central government spending of €12.3 billion (from €79.2 billion to € 65.8 billion).
Pros and cons of austerity policies
Austerity policies raise the pros and cons. Running a thrifty program is painful in the short term, but it pays off in the future.
Some argue the short-term pain may last longer as pessimism spreads and makes the economy worse off. The economic downturn may last up to several years. It caused not only an economic crisis but also a social crisis in which poverty, riots, and crime soared.
Austerity policy drawbacks
Critics argue that austerity hurts not only the economy but also the social conditions in a country. The tax increase leaves households with less money to spend.
Households are more pessimistic. Even though they have worked hard to make money, they cannot enjoy it because they have to pay higher taxes.
Furthermore, cutting government spending has the effect of cutting social programs such as health services and welfare services. Of course, this is detrimental to the lower class people who have been relying on such a program.
Running an austerity program amid an economic downturn will only result in worse conditions. An increase in taxes and cuts in government spending resulted in a decrease in aggregate demand. A fall in aggregate demand causes economic growth to fall further and can lead to a recession. That results in a higher unemployment rate and worsens income prospects.
Austerity policy benefits
On the contrary, proponents say austerity policies are critical. Soaring government debt cripples the economy in the future. Although austerity measures are unpopular, they are necessary to keep the economy on a healthy track.
High debt leads to high-interest rates in the economy. These conditions weigh on growth in the long run. Households and businesses have to pay high-interest charges when applying for new loans or to issue bonds.
Therefore, cutting deficits and debt is a better step to support long-term economic performance. When interest rates fall as debt decreases, it will encourage the private sector to invest.
Investments create more jobs and income, leading to more prosperous households. Businesses are also seeing improved profits. That there ultimately creates more tax revenue.