The Debate Around Austerity

Economists have been arguing about the vitality of Austerity for a long time. It is indeed a controversial matter when it comes to reviving economies. With the emergence of the financial crisis of 2008, it has become even more critical. Is austerity as simple as its name suggests? Let’s try to understand here.

Austerity is a deflationary fiscal policy offering approaches to economies to tackle the budget deficit. The economies can either reduce their spending or increase the taxes (or can do a mix of both) in order to curb its budget deficit.

What is the Need of Austerity?

In an ideal economy, there won’t be any need for austerity. The economies will generate a surplus during an economic boom and accumulate a deficit when there is a recession. Overall surplus and deficit would be able to balance out each other and thus there will be no use of drastic austerity measures. To understand this, let’s take an example – Think about a seasonal worker who saves heavily when the earnings are good and makes use of the savings when the work dries up, an ideal economy is expected to function just like this seasonal worker. 

But in actuality, this is not how economies tend to play out. The economies borrow money even when they are booming and require high levels of spending in a time of crisis like a pandemic or a war. The beauty here is that measures that are conducive for some economies can negatively impact the other economies in similar scenarios. Thus, nations often find themselves in a quandary while managing budget deficit.

What Does History Suggest?

Historic data suggests that if the government chooses the path of cutting its spending to reduce the budget deficit, it leads to increased unemployment in the short-term. The direct impact of the reduction in employment can be seen in the Public sector. Indirectly, though, but the private sector also feels the heat. On the other hand, if the austerity approach of increasing the tax is implemented, it can reduce consumption as a result of lessened disposable income. This will also eventually lead to an increase in unemployment in the short term. In both cases, the GDP of the country will be negatively impacted. Thence, the Austerity policy may result in a higher Debt-to-GDP ratio owing to the reduction in GDP(something that is not desirable).

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Anti-austerity arguments gained prominence in the 1930s during the Great Depression. As per the repercussions, many European countries that embraced austerity measures struggled with rising unemployment and slower GDP growth. Consequently, there was a hike in the debt-to-GDP ratio despite the lessening of budget deficits. These scenarios were perplexing for many economists. Some were doubtful about these measures whereas others were confident about its unacceptability.

John Maynard Keynes has been vocal in criticizing Austerity measures. Contemporary Keynesian Economists put forth the point that cutting government spending can have a multiplier effect on the economy that eventually worsens the situation. As per their argument when a country is in recession, budget deficits are appropriate to reduce unemployment and spur GDP growth. They negate the point that austerity could be of any help when the economy is in recession.

“The boom, not the slump, is the right time for austerity at the Treasury.”

John Meynard Keynes

Is Austerity All Bad? 

Several economists like Alberto Alesina, Carlo Favero, and Francesco Giavazzi advocate a different picture. As per their research, previous work on austerity has not factored in concerns like expectation, incentive, and confidence. Their research suggests that the effect of austerity is not limited to numbers. It also affects people’s attitudes and expectations for the future.

  • Talking about people’s “expectations”- The actions of people aren’t just based on the present situation. They also try to factor in what is going to happen in the future and act accordingly. Therefore, economists like Alberto Alsesina are optimistic about spending cuts. They say if government spending is cut, people will expect tax cuts in the future (since the government won’t need much money). Thus, they will spend more today expecting to pay less tax later. But obviously, this is applicable to only those with disposable incomes.
  • Raising taxes also affect “incentives”- If the government increases taxes, people will find it less attractive to work, especially if they are approaching retirement or are household’s second earner. Thus, this measure could be counterproductive and can result in a higher debt-to-GDP ratio.
  • “Confidence” also plays a crucial role- Investors prefer investing in governments that have control over their economies. When we factor in the confidence of investors while implementing austerity measures, the picture will show spending cuts in a positive light. These cuts send a signal to the investors that the government is making informed decisions and hence will boost their confidence. However, raising taxes will be detrimental to investors’ confidence and should be planned accordingly.
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The Main Challenge

The debate around austerity is actually justified. The difficulty to gauge austerity measures imposes a challenge. This is not only because of the influences of expectations, incentives, and confidence while measuring its impact. The fact that changes due to austerity take place over the course of several years makes the analysis trickier. Various studies show that it is hard to work out if the change in the country’s finances was because of austerity at all. Therefore, there is a need for a narrative approach (factoring in all complex motivations) to the data that may shed new light on the effects of austerity. 

What are your thoughts? Kindly let us know in the comments.

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