Why is austerity important

Most consider this to be a more efficient means of reducing the deficit. New taxes mean new revenue for politicians, who are inclined to spend it on constituents. Spending takes many forms , including grants, subsidies, wealth redistribution, entitlement programs, paying for government services, providing for the national defense, benefits to government employees, and foreign aid.

Any reduction in spending is a de facto austerity measure. At its simplest, an austerity program that is usually enacted by legislation may include one or more of the following measures:. The effectiveness of austerity remains a matter of sharp debate. While supporters argue that massive deficits can suffocate the broader economy, thereby limiting tax revenue, opponents believe that government programs are the only way to make up for reduced personal consumption during a recession. Cutting government spending, many believe, leads to large-scale unemployment.

Although austerity measures may help restore financial health to a nation's economy, reduced government spending may lead to higher unemployment.

Economists such as John Maynard Keynes , a British thinker who fathered the school of Keynesian economics , believe that it is the role of governments to increase spending during a recession to replace falling private demand.

But austerity runs contradictory to certain schools of economic thought that have been prominent since the Great Depression. In an economic downturn, falling private income reduces the amount of tax revenue that a government generates.

Likewise, government coffers fill up with tax revenue during an economic boom. The irony is that public expenditures, such as unemployment benefits, are needed more during a recession than a boom. Perhaps the most successful model of austerity, at least in response to a recession, occurred in the United States between and The unemployment rate in the U.

President Warren G. The program cut public spending and increased taxes often at the expense of Greece's public workers and was very unpopular. Greece's deficit has dramatically decreased, but the country's austerity program has been a disaster in terms of healing the economy. Mainly, austerity measures have failed to improve the financial situation in Greece because the country is struggling with a lack of aggregate demand.

It is inevitable that aggregate demand declines with austerity. Structurally, Greece is a country of small businesses rather than large corporations , so it benefits less from the principles of austerity, such as lower interest rates. These small companies do not benefit from a weakened currency, as they are unable to become exporters.

While most of the world followed the financial crisis in with years of lackluster growth and rising asset prices, Greece has been mired in its own depression. Greece's problems began following the Great Recession, as the country was spending too much money relative to tax collection. As the country's finances spiraled out of control and interest rates on sovereign debt exploded higher, the country was forced to seek bailouts or default on its debt.

Default carried the risk of a full-blown financial crisis with a complete collapse of the banking system. It would also be likely to lead to an exit from the euro and the European Union. Wharton University of Pennsylvania. Or Does it Make Things Worse? National Bureau of Economic Research. Accessed Jan. Cato Institute. The American Presidency Project. World Bank. United Nations. Fiscal Policy. Actively scan device characteristics for identification.

Use precise geolocation data. One way to return these idle resources to productive use more quickly is for the government sector to put these resources to work and increase aggregate demand. The government can either do this directly—by spending more—or indirectly—by cutting taxes, so that the private sector has more money to spend and invest.

In the simplest terms, stimulus and austerity represent opposite reactions, typically to a recession. Recessions result in lower tax revenues, and a government can respond by either doing nothing—in which case it runs a budget deficit—or by engaging in stimulus or austerity. How well this stimulus works is a crucial question for economists. Unfortunately, it is difficult to precisely measure the effects of these policy changes in a depressed economy. Patients always feel worse after a procedure than they did before the crash, but that is hardly informative about how the procedure worked, as it is likely the discomfort is from the effects of the accident.

Likewise, it is difficult to measure the effectiveness of fiscal intervention in the economy precisely because the relevant fiscal interventions are only recommended if the economy is experiencing severe negative shocks. Here, Romer is getting at the issue of counterfactuals.

In perfect scientific experiments, researchers recruit and treat a control group and a treatment group so they can know the effect of doing everything but the procedure they are studying, as well as the effect of everything and the procedure they are studying. Economists do not get to do that.

There is only one economy, so it is not moral to experiment on it. Consequently, economic researchers only get to try things that are believed to be likely to work, and they have to be clever about finding ways to separate out the effects of the policy they want to study from everything else that happens in the economy. This problem is endemic to economic research, and it is a uniquely difficult challenge in studying activist fiscal policy.

This is an active area of academic debate, so consensus does not imply certainty or uniformity of opinion, but there have been three major shifts in our understanding of fiscal policy since the end of World War II. The first is the original rise of Keynesian economics, which lasted through the s and held that the government should take a very active role in stabilizing the economy. The second is the rational-expectations revolution that rose to prominence in the s and was the consensus view in academic economics until fairly recently.

Under this view, stabilization of the economy was certainly not a task for fiscal policy. Two of the more striking findings from this work were the ideas that the costs of recessions are quite small and that even if the government tried to stimulate the economy, rational citizens would increase their own private savings during any short-term increase in public debt in anticipation of future tax increases, negating any attempt at fiscal stimulus.

Although policymakers have never fully converted to this view, it has been the dominant paradigm in academic circles for a generation. The slow recovery from the Great Recession, amid austerity on both sides of the Atlantic, has coincided with new research in economics and generated a strong theoretical and empirical foundation for the work that policy economists have been doing all along. In most instances, these interventions are best conducted through monetary policy.

During large recessions, however, managing fiscal policy is often deemed superior because the economy is more responsive to monetary contractions than to expansions. Also, in a sufficiently deep recession, the interest rates needed to stimulate the economy can be negative.

Macroeconomics textbooks have long subscribed to the view that there are different approaches and techniques that we should use when studying short-term fluctuations and long-term growth in an economy and that the two are driven by distinct, independent factors. In the short term, Keynesian models have been used to justify and design fiscal and—to a greater extent—monetary interventions that keep the economy within acceptable parameters by managing demand.

In the long term, the proper understanding is that investment, capital accumulation, and the size and skill level of the labor force are the key drivers of economic growth and that demand is assumed to meet output. Under this convention, long-run changes in the growth rate of the real economy must be the result of shocks, or policy changes, that change aggregate supply.

Economists make strong distinctions between the short run and the long run. In the long run, demand is assumed to meet supply, but in the short run, this need not hold.

Governments and central banks can affect aggregate demand, but aggregate supply is driven by long-term fundamentals that are difficult to actively manage. In the long run, when supply and demand are balanced, raising demand has no effect on output and only increases prices.

Economists recognize that sharp distinctions between the short run and the long run are a bit artificial, but until this recession, the idea that long-run supply is independent of short-term demand was widely accepted. New research since the recession reveals that insufficient demand alone over a long-enough period of time can actually cause aggregate supply to fall.

This reduces the speed limit—or potential GDP—of the long-run economy. Potential GDP is the level of GDP that it is possible to achieve for a given aggregate supply without increasing the rate of inflation beyond an acceptable range. The growing role of human capital in the economy has called this approach into question.

Just as physical capital depreciates over time—consider what a five-year-old computer is worth, for example—so can human capital, especially if workers lose contact with the latest developments in their fields of expertise. Since the onset of the Great Recession, the shift in expert opinion on this topic has been more dramatic than on any other—if only because the existing consensus was so strong.

Before the recession, the accepted wisdom was that macroeconomic shocks could either affect aggregate supply or aggregate demand. Supply shocks—such as a spike in oil prices—would move the potential GDP of the economy, and demand would eventually adjust, balancing at the new level of supply.

Our previous understanding of demand shocks was that they could cause a temporary increase or decrease in GDP but would have no effect on long-run aggregate supply or potential GDP. Consequently, any effect of a demand shock would have to be temporary, and only supply-side shocks could cause long-term changes in the potential GDP of the economy. Olivier J. Blanchard and Lawrence H. Summers first suggested a short-term to long-term demand-side interaction in their examination of post growth in European unemployment.

At the time, the fact that the problem existed for European economies and not the United States led the authors to suspect that less-flexible European labor markets were translating short-term shocks into long-term growth slowdowns, because higher long-term unemployment reduces the stock of human capital.

As recently as , J. Bradford DeLong and Summers presented research that pointed out the possibility that a similar dynamic may be at play in the United States during the continued slow recovery from the Great Recession. Their central argument was that if we accept the possibility that fiscal intervention can affect long-run aggregate supply, the costs of fiscal stimulus are much lower than previously thought, and activist fiscal policies should be pursued more often.

Typical estimates implicitly assume the economy will return to its previous trend and potential GDP, but our experience over the slow recovery shows this is not always the case. As drew to a close, this view gained considerable validation, with a paper by three economists in the research division of the Federal Reserve Board—Dave Reifschneider, William L.

Wascher, and David Wilcox—suggesting that the costs of the prolonged slump could be very large, permanently reducing GDP by as much as 7 percent per year. Empirically demonstrating that recessions can produce long-run effects in labor markets was a much tougher task given the data requirements, but this too has been a productive avenue for research since the beginning of this recession. As data quality has improved over the past 20 years, this question has become one that can be answered, and it increasingly appears as if short-term shocks do have long-term costs to individuals.

This is important because it upends the conventional wisdom that the long-term cost of doing nothing is essentially zero. This new research indicates that even a fiscal multiplier of less than 1 may still correspond with a prudent policy, due to the long-term downside risks to GDP from hysteresis.

This term is used to describe how large an effect on the entire economy we can expect for a given fiscal intervention. Davis and Till von Wachter show that workers who are displaced from employment during the mass layoff episodes often associated with recessions experience significant, permanent losses in lifetime earnings. A worker who is laid off when the unemployment rate is more than 8 percent can expect to lose twice as much in lifetime earnings as one who loses a job when the unemployment rate is less than 6 percent.

More recently, Alan B. Kreuger, Judd Cramer, and David Cho have presented research suggesting that a disturbingly large fraction of workers who are unemployed for long periods of time never fully regain stability in the labor force, possibly due to individual specific factors, statistical discrimination against the long-term unemployed, or a combination of the two.

Another structural change in U. Until , recoveries from recessions tended to involve rapid increases in GDP and employment—colloquially called V-shaped recoveries because most data series exhibited a rapid fall and rapid return to baseline—but the , , and recessions all broke from this pattern with rapid falls followed by slow recoveries.

This formed the pattern that gives rise to the so-called L-shaped recovery. Olivier Coibion, Yuriy Gorodnichenko, and Dmitri Koustas found significant evidence of Amerisclerosis in a retrospective look at the U. Instead, their lesson for policymakers is forward looking: The structure of the U. If that is true, then ensuring that stimulus does not last too long—one of the primary practical problems of devising such a program—is far less worrisome.

Longer-lasting fiscal stimulus programs are more appropriate if L-shaped recoveries continue, as they pose both less risk of inflation due to mistiming and are less likely to end too soon, induce premature austerity, and harm long-term growth prospects.

Removing an appendix that is about to burst prevents a life-threatening infection and is a useful treatment, but removing a healthy appendix will leave the patient in pain and with unnecessary holes in the abdomen.

The effectiveness of the treatment is state dependent: Its benefit can be positive or negative depending on the health of the appendix. The traditional estimate of the effectiveness of fiscal policy is a fiscal multiplier that is not state dependent, equivalent to estimating the benefits of arbitrarily taking out an appendix without first checking to see if the appendix is about to burst.

If we assume that policymakers have no ability to discern whether the economy is healthy, this is the optimal approach, but that is a pretty extreme assumption. In a way, the remarkable thing about economic policy in was the fact that the case for fiscal stimulus made any headway at all against the forces of incomprehension and vested interests demanding harsher and harsher austerity.

If this is right, there was inevitably going to be a growing backlash — a turn against stimulus and toward austerity — once the shock of the crisis wore off. Indeed, there were signs of such a backlash by the early fall of But the real turning point came at the end of that year, when Greece hit the wall. But they had a problem: their dire warnings about the consequences of deficit spending kept not coming true.

Some of them were quite open about their frustration with the refusal of markets to deliver the disasters they expected and wanted. This is regrettable, because it is fostering a sense of complacency that can have dire consequences.

Suddenly, austerians had a concrete demonstration of the dangers they had been warning about. A hard turn away from Keynesian policies could now be justified as an urgent defensive measure, lest your country abruptly turn into another Greece. Still, what about the depressed state of western economies? The post-crisis recession bottomed out in the middle of , and in most countries a recovery was under way, but output and employment were still far below normal.

Standard macroeconomics said that cutting spending in a depressed economy, with no room to offset these cuts by reducing interest rates that were already near zero, would indeed deepen the slump. But policymakers at the European Commission, the European Central Bank, and in the British government that took power in May eagerly seized on economic research that claimed to show the opposite.

The reason, he and those who seized on his work suggested, was that spending cuts create confidence, and that the positive effects of this increase in confidence trump the direct negative effects of reduced spending.

This may sound too good to be true — and it was. The doctrine of expansionary austerity quickly became orthodoxy in much of Europe. At most, the Reinhart and Rogoff paper provided a backup bogeyman, an answer to those who kept pointing out that nothing like the Greek story seemed to be happening to countries that borrowed in their own currencies: even if interest rates were low, austerians could point to Reinhart and Rogoff and declare that high debt is very, very bad.

What Reinhart and Rogoff did bring to the austerity camp was academic cachet. Their book This Time is Different, which brought a vast array of historical data to bear on the subject of economic crises, was widely celebrated by both policymakers and economists — myself included — for its prescient warnings that we were at risk of a major crisis and that recovery from that crisis was likely to be slow.

So they brought a lot of prestige to the austerity push when they were perceived as weighing in on that side of the policy debate. They now claim that they did no such thing, but they did nothing to correct that impression at the time. When the coalition government came to power, then, all the pieces were in place for policymakers who were already inclined to push for austerity.

Fiscal retrenchment could be presented as urgently needed to avert a Greek-style strike by bond buyers. Economists who objected to any or all of these lines of argument were simply ignored. The first chart shows interest rates on the bonds of a selection of advanced countries as of mid-April What you can see right away is that Greece remains unique, more than five years after it was heralded as an object lesson for all nations.

Everyone else is paying very low interest rates by historical standards. This includes the United States, where the co-chairs of a debt commission created by President Obama confidently warned that crisis loomed within two years unless their recommendations were adopted; that was four years ago.

It includes Spain and Italy, which faced a financial panic in , but saw that panic subside — despite debt that continued to rise — once the European Central Bank began doing its job as lender of last resort. It includes France, which many commentators singled out as the next domino to fall, yet can now borrow long-term for less than 0.

And it includes Japan, which has debt more than twice its gross domestic product yet pays even less. Well, those bond vigilantes have stayed invisible. Such countries cannot, after all, run out of money, and if worries about solvency weakened their currencies, this would actually help their economies in a time of weak growth and low inflation.

Chart 2 takes a bit more explaining. A couple of years after the great turn towards austerity, a number of economists realised that the austerians were performing what amounted to a great natural experiment. Historically, large cuts in government spending have usually occurred either in overheated economies suffering from inflation or in the aftermath of wars, as nations demobilise.

Neither kind of episode offers much guidance on what to expect from the kind of spending cuts — imposed on already depressed economies — that the austerians were advocating. But after , in a generalised economic depression, some countries chose or were forced to impose severe austerity, while others did not. So what happened? In Chart 2, each dot represents the experience of an advanced economy from to , the last year of major spending cuts. The horizontal axis shows a widely used measure of austerity — the average annual change in the cyclically adjusted primary surplus, an estimate of what the difference between taxes and non-interest spending would be if the economy were at full employment.

As you move further right on the graph, in other words, austerity becomes more severe. You can quibble with the details of this measure, but the basic result — harsh austerity in Ireland, Spain, and Portugal, incredibly harsh austerity in Greece — is surely right.

Meanwhile, the vertical axis shows the annual rate of economic growth over the same period. The negative correlation is, of course, strong and obvious — and not at all what the austerians had asserted would happen. But why did the alleged statistical evidence — from Alesina, among others — that spending cuts were often good for growth prove so misleading?