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Monday, May 6, 2013

Does Austerity Work?

Does raising taxes and cutting government spending reduce a government’s deficits and thus debt? Confine consideration to more tax revenue and less spent and the theoretical answer is yes; it being a simple matter of mathematics. Include the impacts of raising taxes and cutting spending and the answer become far less straightforward. More paid in tax means less disposable income, which means less consumption and thus less produced (i.e., GNP). A government spending less also means less consumption in the economy, and therefore even less to be produced to meet demand. In short, austerity is recessionary. Whether the ratios of deficit and debt to GDP increase depends on how much the numerators drop relative to the decrease in GDP. We can look at the E.U. for some empirical evidence.
For the states that have adopted the euro currency, government spending exceeded tax revenue by 3.7% in 2012, down from 4.2% in 2011. Add in the remaining E.U. states and those figures are 4 and 4.4 percent. In fact, 2012 was the fourth straight year of deficit reductions in the European Union. So far, everything looks to be in line with the theory: adding revenue and reducing what is spent reduces a deficit. Lower deficits in turn mean that the government debt does not increase as much from year to year than would be the case were the deficits larger.
Unfortunately, as the excess spending was reducing in percentage terms over the revenues collected, the debt burden, which is simply the government debt relative to GDP, was increasing. In the states that use the euro, government debt as a percentage of total economic output, or GDP, increased to 90.6% in 2012 from 87.3% in 2011. Include the remaining states and public debt rose to 85.3% from 82.5 percent. Interestingly, the difference between the “euro-zone” and the entire Union was around 5% in both years. Relative to the E.U. as a whole, the euro-zone debt burden had not improved or worsened. Both the euro-zone and all of the E.U. states together saw a roughly 3% debt-burden increase. Why is that?
For the states undergoing austerity, decreases in GDP exceeded the decreases in the deficits. Although exogenous factors such as a dip in global trade could have played a role, it is also possible that the recessionary impacts of the austerity exceeded the decrease in the deficits. Austerity reduces demand in the economy and increases unemployment, which in turn puts pressure of governments to increase social spending—either by raising taxes or increasing the deficit, and thus debt. It can be a rather vicious cycle, with the most vulnerable people put most at risk. Even if GDP contracts without any increase in the deficits, we would expect to see the total debt-burden in the euro-zone worsen relative to the combined debt-burden of all the E.U. states, unless a number of non-euro-zone states were also undergoing austerity.
                                           If austerity kills dignity, then pressure on governments to relax spending cuts can be expected.   source: rt.com
In any case, at least some experts have concluded that austerity in practice is less stellar than its advocates have admitted. Ben May, an economist at Capital Economics, argues that “the fact that most economies’ deficits have fallen by less than expected and that the consolidation has coincided with deeper than anticipated recessions confirms that the costs have been large.” He noted that the state of Germany, which posted a budget surplus in 2012, accounted for 60% of the improvement. Yet how is it then that the debt-burden of the euro-zone did not change in percentage terms relative to all of the states put together?


David Jolly, “E.U. Austerity Shrinks Deficits, If Not Debt,” International Herald Tribune, April 23, 2013, p. 15.