Define Austerity

Austerity

What Exactly Is Austerity?

The phrase "austerity" refers to a set of economic measures implemented by a government in order to reduce public debt. When a government's public debt gets so big that default or the inability to meet its commitments becomes a genuine possibility, the government implements austerity measures.

In a nutshell, austerity aids governments in regaining financial health.

 Default risk may swiftly spiral out of control, and lenders will charge a greater rate of return for future loans as an individual, firm, or country falls further into debt, making it more difficult for the borrower to secure funds.

TAKEAWAYS IMPORTANT

• Austerity refers to government-imposed severe economic policies characterised by increasing austerity in order to control rising public debt.

• Revenue generation (more taxes) to pay expenditure, rising taxes while eliminating non-essential government operations, and lower taxes and reduced government spending are the three main forms of austerity policies.

• Austerity is divisive, and the consequences of austerity policies can be far worse than if they had not been implemented.

• During periods of economic turmoil, the United States, Spain, and Greece all used austerity measures.

What is the Process of Austerity?

When a government's debt exceeds the amount of money it receives, it faces financial instability, resulting in significant budget deficits.

When government expenditure rises, debt levels rise as well. As previously stated, this means that federal governments are more likely to default on their debts. To avoid defaulting on these payments, creditors want higher interest rates. They may have to take particular steps to satisfy their creditors and keep their debt levels under control.

Austerity is only implemented when the gap between government income and expenditures narrows. When governments spend too much money or take on too much debt, they wind up in this scenario. As a result, when a government owes more money to its creditors than it gets in income, austerity measures may be necessary. Implementing these steps helps to restore economic confidence while also restoring some sense of fiscal balance to government budgets. 

Governments are prepared to take efforts to restore some financial health to their budgets through austerity measures. As a result, when austerity measures are in place, creditors may be ready to cut loan interest rates. However, these changes may be subject to certain restrictions.

For example, after Greece's first bailout, interest rates on its debt decreased. The advantages, however, were confined to the government's reduced interest rate costs. Large businesses are the main beneficiaries of lower rates, despite the fact that the private sector was unable to gain. Reduced rates benefited consumers only little, but the absence of long-term economic development kept borrowing at low levels despite the lower rates.

Particular Points to Consider

Austerity does not always entail a reduction in government spending. In reality, governments may be forced to take these steps during specific economic cycles.

For example, the global economic crisis that began in 2008 resulted in lower tax receipts for many governments, exposing what some saw as unsustainable expenditure levels. Several European countries, notably the United Kingdom, Greece, and Spain, have implemented austerity measures in order to address budgetary difficulties.

During the global crisis, austerity became nearly mandatory in Europe, because eurozone countries lacked the ability to handle growing debts by printing their own currency. As the prospect of default loomed, creditors put pressure on several European nations to cut expenditure drastically.

Austerity in its various forms

In general, there are three different sorts of austerity measures:

• Increased taxation is a means of raising money. This strategy is frequently used to justify increased government spending. The idea is to encourage expenditure while also collecting benefits through taxation.

• Angela Merkel is a role model. This plan, named after Germany's chancellor, aims to raise revenue while reducing non-essential government activities.

• Lower taxes and less expenditure by the government. This is the way that proponents of free markets prefer.

Taxes

The impact of tax policy on the government budget is a point of contention among economists. Arthur Laffer, a former Reagan adviser, famously stated that intentionally lowering taxes would boost economic activity, resulting in greater income.

Despite this, the majority of economists and policy analysts think that hiking taxes will increase revenue. Many European countries adopted this strategy. In 2010, Greece, for example, increased its value-added tax (VAT) rates to 23 percent. 2 The government increased income tax rates for those in the highest income brackets while also introducing additional property taxes.

Government Spending Cuts

Reduced government expenditure is the polar opposite of austerity. Most people believe that this is a more efficient way to reduce the deficit. New taxes bring in more money for politicians, who are more likely to spend it on their voters.

Grants, subsidies, income redistribution, entitlement programmes, paying for government services, financing for national security, rewards to government employees, and international aid are all examples of spending. Any cut in spending is a form of de facto austerity.

• An austerity programme, which is normally adopted through legislation, can comprise one or more of the following policies at its most basic level:

• Government pay and perks are slashed or frozen without rises.

• Government employment and layoffs are both on the chopping block.

• Government services are reduced or eliminated, either temporarily or permanently.

• Pension reform and reduction by the government

• Interest rates on freshly issued government securities might be reduced, making these investments less appealing to investors while lowering government interest commitments.

• Government expenditure initiatives such as infrastructure building and maintenance, health care, and veterans' benefits will be cut.

• Increases in income, corporate, property, sales, and capital gains taxes are all on the rise.

• To address the issue, the Federal Reserve will reduce or increase the money supply and interest rates as circumstances warrant.

• Rationing of essential goods, travel restrictions, price freezes, and other economic controls, especially during times of war, are all examples of economic controls.

Austerity criticism

The effectiveness of austerity is still a hot topic of discussion. While proponents claim that large deficits choke the economy, restricting tax income, opponents contend that government programmes are the only way to compensate for lower consumer consumption during a recession. Many people assume that cutting government expenditure leads to widespread unemployment. 

They argue that more government expenditure decreases unemployment and hence increases the number of people paying income taxes.

IMPORTANT  : Although austerity measures may help a country's economy recover its financial health, lower government expenditure may result in more unemployment.

Economists like John Maynard Keynes, a British thinker who founded the Keynesian school of economics, argue that governments should raise expenditure to compensate for decreased private demand during a recession.  The theory goes that if the government does not prop up and stabilise demand, unemployment will continue to grow and the recession will last longer.

However, austerity goes counter to some economic schools of thinking that have dominated since the Great Depression. Falling private income decreases the amount of tax revenue a government generates during a downturn. Similarly, during an economic boom, government coffers are brimming with tax income. Ironically, government spending, such as unemployment compensation, is required more during a recession than during a boom.

Austerity examples

United States of America

Between 1920 and 1921, the United States had perhaps the most effective form of austerity, at least in reaction to a recession. The unemployment rate in the United States increased from 4% to over 12%. 4 The real gross national product (GNP) fell by about 20%, the steepest drop since the Great Depression or the Great Recession.

President Warren G. Harding retaliated by slashing the government budget by nearly half. Tax rates were lowered for all income classes, and the national debt was cut by more than 30%. 5 Harding vowed in a speech in 1920 that his administration "would undertake intelligent and daring deflation, and strike at government borrowing...[and] will tackle excessive government costs with every energy and facility." 

Greece

The EU and the European Central Bank (ECB) agreed to an austerity programme in exchange for bailouts, with the goal of bringing Greece's finances under control. The policy was unpopular since it decreased public expenditure and raised taxes, frequently at the cost of Greece's public employees. Although Greece's deficit has shrunk substantially, the country's austerity policy has been a failure in terms of economic recovery.

Austerity measures have mostly failed to improve Greece's financial predicament since the nation is experiencing a shortage of aggregate demand. With austerity, aggregate demand will inevitably fall. Because Greece is structured as a country of small enterprises rather than giant corporations, it benefits less from austerity concepts like reduced interest rates. Because they are unable to become exporters, these small businesses do not gain from a weakening currency.

While the rest of the globe has seen years of stagnant growth and soaring asset values as a result of the financial crisis in 2008, Greece has been buried in its own slump. In 2010, Greece's gross domestic product (GDP) was $299.36 billion dollars. 7 According to the United Nations, its GDP was $235.57 billion in 2014. 8 This is comparable to the Great Depression in the United States in the 1930s in terms of the country's economic status.

Greece's woes began after the Great Recession, when the country spent far more money than it collected in taxes. The government was compelled to seek bailouts or default on its debt as its finances spun out of control and interest rates on sovereign debt rocketed higher. Default posed the threat of a full-fledged financial catastrophe, with the banking system collapsing. It is also likely to result in a withdrawal from the eurozone and the EU.