Austerity is an economic policy that focuses on raising taxes and reducing government spending. We refer to these spending or budget cuts as ‘cutbacks.’ Although the term suggests just reducing spending rather than also raising taxes, in economics, it refers to both.
Governments typically adopt cutback measures when there are economic problems, especially when they cannot pay their debts.
The government may, for example, borrow in a foreign currency, which it cannot issue. Additionally, when a government loses the authority to print money, austerity is the only option left.
When this type of situation occurs, banks and investors lose confidence in the governments’ ability to pay back debt. The government or central bank might refuse to refinance existing debts or significantly increase interest rates.
However, the International Monetary Fund (IMF) may act as a lender of last resort. The IMF will only lend if the borrowing government adopts a specific economic policy. The IMF calls this type of policy its austerity conditionalities.
Goals when adopting austerity measures
When the government imposes cutback measures, it has three main goals:
- First, to avoid the accumulation of deficits that increase total debt.
- Second, to reduce high inflation.
- And finally, to limit over-investment and speculative bubbles.
Government cutbacks and tax hikes tend to push up unemployment. Higher unemployment results in increases in spending on unemployment benefits. Furthermore, if fewer people are working the government is collecting less tax.
Put simply; rising unemployment is a problem because it partially offsets the austerity measures.
Balancing stimulus and austerity
It is possible to take steps that ensure future spending will go down. For example, Parliament can pass a bill raising the retirement age. If people start collecting their state pensions later, the government’s pension bill will be cheaper.
The measures to reduce spending further may allow for greater short-term spending to create jobs.
Controversy
Measures involving cutbacks are controversial. Not only do most members of the general public dislike them, but also many economists.
The Overseas Development Institute (ODI) briefing paper – “The IMF and the Third World” – points out several problems with the IMF’s austerity conditionalities.
The paper concludes that these measures are anti-development and self-defeating. Additionally, the paper authors claim that they are especially harmful to the poorest people in the country.
Austerity measures can also have a profound social impact, often necessitating reforms in social welfare programs and affecting the provision of public services.
Keynesian school of thought
At the end of the 1930s, after almost ten successive years of austerity measures in response to the Great Depression, a growing number of economists argued against cutbacks. John Maynard Keynes (1983-1946), a British economist, became very famous for his anti-austerity views.
Keynes argued that “The boom, not the slump, is the right time for austerity at the Treasury.”
Keynesian economists argue that there should be a deficit during a recession. The deficit helps reduce unemployment, which subsequently boosts GDP growth. GDP stands for gross domestic product.
On 2 June 2014, Jonathan Ostry, deputy director of the IMF research department, warned in the blog IMFDirect against austerity. He wrote that governments which face lower risks of a sovereign debt crisis could be unnecessarily damaging their economies by imposing harsh austerity programs purely to pay back creditors more rapidly.
Video explanation
This video presentation explains what ‘Austerity’ is using simple and easy-to-understand language and examples.