Austerity

The term austerity has been given to a policy of cuts in government and/or increases in taxation. A number of countries adopted, or were obliged to adopt, such policies in response to the 2008 financial crisis and the Greek debt crisis in 2010.

The stated aims of austerity were: to reduce the size of the government’s budget deficit and thereby eventually to reduce its debt to GDP ratio; to increase confidence in its finances and so encourage investment expenditure; and, for certain Eurozone countries especially, to stimulate exports – and hence aggregate demand for their goods and services – by reducing wages and prices relative to other Euro-zone members.

Many macroeconomists were sceptical of some of these claims, particularly at a time when the ability of monetary policy to counter fiscal policy’s effects by reducing interest rates was limited by the already low level of interest rates. They argued that elementary macroeconomics implies that in these circumstances austerity would reduce aggregate spending at a time when private sector spending was still low; would harm rather than improve confidence; and would, given relatively sticky wages and prices, increase the severity of – and prolong – the recession caused by the 2008 financial crisis, and hence reduce tax revenues. They also argued that the latter two effects meant that austerity would make only a small improvement in the actual government deficit and could well lead to a worsening of the debt to GDP ratio. Finally they felt that the required relative price adjustment for Euro-zone countries could be less brutally achieved if countries in strong fiscal positions, e.g. Germany, followed more expansionary policies which would raise their prices.

A good indicator of the degree of austerity is the government’s cyclically-adjusted primary balance – this shows what the deficit (excluding interest payments) would be if the economy were operating at its full capacity.

On this measure, all the countries had expansionary fiscal policies in 2009 – the measure is negative. This expansionary policy was mainly in response to the financial crisis of 2007/8 and resultant fall in private sector spending. But then Portugal, Spain and Greece all adopted varying degrees of austerity between 2009 and 2013, mainly in response to the “Greek debt crisis”. As indicated by the greater upward slope of its line, Greece’s programme was especially severe. Ireland adopted austerity a year or so earlier in response to its own banking crisis in 2008. In Portugal, Greece and Spain austerity was relaxed a little in 2014.

How have things turned out?

Real GDP fell in all countries after the austerity policy was adopted, especially in Greece. This decline in output appears to have halted around 2013/4, perhaps a little earlier in Ireland where output now appears to be growing quickly. But by the end of 2014 GDP had yet to reach its 2007 level in any of the countries except Ireland where that level was just reached in 2014q4. Given that most of these countries would normally be expected to grow at around 2% per annum this suggests that they are all still operating around 10-15% below full capacity – even more in the case of Greece.

Unemployment rose sharply in all these countries – in Spain and Greece reaching levels associated with the Great Depression of the 1930s – though by 2014 the rise seem to have been mildly reversed.

The imposition of austerity has led to falls in unit labour costs – in most cases back to the level they were in 2007. And at the same time prices relative to the Eurozone have fallen in all the countries except Portugal.

Fiscal austerity has led, as planned, to a reduction in the countries’ actual budget deficits as a % of GDP, though, as measured by the most quoted measure of the deficit – the Overall Balance or Public Sector Net Borrowing – all the governments’ budgets were still in deficit in 2014, thus adding to government debt. This, together with the decline in GDP, has meant that in all the countries the debt to GDP ratio was higher – in most case much higher – in 2014 than it was when increasing austerity was initiated, though this ratio is predicted
to stabilise or fall over the next 5 years.

Overall, the last 5 years have more closely followed the predictions of austerity’s critics than of its advocates. The severity and length of the recession has been greater and more prolonged than the latter predicted, partly because increasing austerity did not have the predicted effects on confidence and private sector spending. As a result the beneficial effects on government deficits have been much slower to appear and we have yet to see significant falls in the countries’ debt to GDP ratios. Even Ireland’s experience can be seen as merely supporting conventional theory: a prolonged and severe recession slowly but eventually led to falls in Ireland’s prices relative to those of other countries and hence an increase in its competitiveness and a rise in its exports. This has fuelled a sustainable increase in its GDP, though its GDP has still only just reached its 2007 level.

Advocates of austerity ask: what was the alternative? Austerity’s critics recommended that the reduction in budget deficits should be much slower and indeed should probably have been delayed altogether until these economies had pulled out of the recession caused by the 2008 financial crisis. This, they claim, would have led to less of a collapse in output and tax revenues and eventually less of a rise in debt to GDP ratios. Of course we cannot be certain whether these alternatives would have worked or produced problems of their own – austerity’s advocates suggested that such policies would have created concerns about whether government deficits and debt ratios would ever be dealt with and that this uncertainty would have had dramatic effects on interest rates and investor confidence.