Austerity is a set of economic policies put together by the government to regulate debt in the public sector. Austerity doesn’t necessarily work for every country. There are instances of its implementation leading to a worsened economy than before. The three main types of austerity include increasing taxes to generate government revenue, increasing taxes and reducing non-essential government expenditure and reducing both taxes and government expenditure.
The word austerity is commonly used in relation to economic policies and public debt. Austerity measures are implemented when a government feels that the volume of public debt is too large that it might lead to default when the payments are due.
If the debt is too large, payment default can snowball into repeated defaults. This will make the cost of borrowing in the future much higher since lenders will charge a higher rate of interest or it may even become difficult to get loans in the future because of the previous defaults. In short, austerity helps to improve a government’s financial situation.
How does austerity work?
Governments borrow money on a regular basis to finance their activities. When the amount they borrow becomes much larger than the revenue they receive, it becomes difficult for governments to repay their debts and it results in massive budget deficits.
As government spending increases, their debts also increase. And if this goes on, governments will be at a high risk of not being able to repay their debts on time. To protect themselves, lenders will start charging high-interest rates. As such, the government will have to bring certain safety measures to control their spending and ensure that their debts don’t pile up.
This is where austerity comes into the picture. When government debt accumulates beyond a reasonable level and spending outweighs income, austerity measures are implemented.
Austerity measures bring assurance to the economy that the government is taking measures to curb its spending and balance its budgets as well.
When austerity measures are taken, creditors may reduce their interest rates since the government is looking to reduce their debts. This may not necessarily translate into economic stability and development though. Unless the private sector is able to benefit directly from austerity measures, the common man will not benefit from it. Sustainable economic development will not happen either if consumers benefit only marginally from such measures.
Various types of austerity
Austerity is of three types:
- The Angela Merkel model: This model looks at bringing about financial stability in the economy by raising tax rates and reducing government expenditure.
- Increasing taxes to generate revenue: In this method, government spending is encouraged. The aim is to encourage growth through spending and use the growth to increase taxes and generate revenue.
- Reduce taxes and government expenditure: Advocates of free-market principles prefer this method of austerity. It involves reducing taxation while also lowering government spending.
Increasing taxes to generate government revenue
Economists have always been divided on the role of taxation policies on government budgets. It has been argued that reducing taxes will increase the spending power of the consumers which will, in turn, spur economic growth. On the other hand, a whole lot of economists say that the best way for the government to increase its income is to raise the tax rates. This is a methodology consistently followed by many European countries to boost national revenue.
Bettering financial health through reduced government spending
At the other end of the spectrum is the austerity measure of reducing government spending in a bid to bring stability to national budgets. This is usually considered to be the better option when trying to reduce the gap between government income and expenditure. Increased or new taxes means more money for government officials who will use the funds for constituency needs.
Government spending includes money spent on granting subsidies, entitlement programs, benefits to government employees, grants, free government services, national defense and foreign aid. An austerity measure will look at reducing any or many of these expenses. This can be done in many ways such as:
- Reducing or freezing salaries and benefits for government employees.
- Government pension reform and reductions.
- Increasing taxes on income, sales, property, corporate activities, and capital gains.
- Layoffs of government employees and a freeze on hiring for the moment.
- An increase or decrease in interest rates and supply of money as determined by the Federal Reserve.
- Reduction in interest on government securities that have been recently issued. This will attract fewer investors and hence the interest obligations of the government will reduce.
- Introduction of cuts to planned government spending programs including veterans’ benefits, healthcare, infrastructure, etc.
Examples of austerity
Let’s look at a few examples of how austerity was used in the past.
Greece
The European Central Bank and the EU looked at bringing more control to Greece’s national finances by using austerity measures through bailouts. The program was heavily criticized since it focused on cutting public expenditure and increasing taxes. These measures were taken at the expense of public employees. While Greece’s deficit has decreased to a large extent, the austerity measures that were implemented have not helped heal the economy.
The main reason for the failure of the austerity program implemented in Greece is the fact that Greece is not a country of large corporations but small businesses. Therefore, the country does not have aggregate demand. The country as a whole does not benefit from austerity programs.
The United States of America
The U.S., unlike Greece, has perhaps one of the best examples of achieving success in implementing austerity measures. During the recession between 1920 and 1921, the gross national product reduced to about 20%. The unemployment rate in the country skyrocketed from 4% to 12%.
The government’s response was to cut the federal budget by about 50%. This along with reduced tax rates across all income groups led to a national debt reduction of over 30%.
Criticisms
Austerity is not without its share of criticisms. Whether austerity is actually effective has been debated through the ages, especially during times of recession. Many opposing the idea of austerity feel that the only way to balance decreased personal consumption is through government programs. They argue that reducing government expenditure will only lead to unemployment on a massive scale which will further cripple a slow economy.
The logic is that with increased government spending, there is more employment. As a result, the number of taxpayers goes up, increasing the government’s income. The government needs to stabilize the economy and reduce unemployment so that recession can run its course quickly.
