Are austerity measures self-defeating? To see more of our products visit our website at Andrew Threadgould, Dulwich College

These are policies pursued by governments to reduce the size of the budget deficit. C A deficit reduction strategy requires either cuts in spending, increases in taxation or both. C Government budgets have been a particular problem since the recession of C Austerity measures When a government has a budget deficit this must be funded using either money from previous budget surpluses or through issuing bonds. C

This traditionally proposes that the role of the government and central bank is to smooth out fluctuations in GDP growth. C In a boom, contractionary policies are used to reduce excessive growth in aggregate demand. C Here tax rates are increased, government spending programmes cut back, and interest rates increased to raise the cost of borrowing for both households and firms. C Keynesian macroeconomic management policy In periods of slowdown or recession, expansionary policies are used to stimulate aggregate demand. C Here there are lower tax rates and interest rates, and increases in government expenditure to create jobs both directly (through increased public sector employment) and indirectly (as a result of the multiplier effect. C

This was the case in the 1970s as the cost of sustaining an extensive welfare state became unsustainable against a backdrop of deindustrialisation, oil crises and industrial unrest. C Neo-liberal policies were used in the UK and USA during the early 1980s, arguing the case for a smaller government, lower rates of tax and budgetary balance and prudence. C The New Labour government from 1997 embarked on an extensive programme of government expenditure and cuts in the basic rate of income tax. C Keynesian policies under pressure Despite the period being generally one of strong GDP growth, from onwards the budget was in deficit every year. C

The impact of the financial crisis of and the subsequent recession across Europe and North America led to a sharp increase in the deficit in C Manufacturing output and house prices fell by 10%, household saving increased from 3.1% to 7.8% of average income, and unemployment increased by 500,000 – 600,000. C In the UK real GDP fell by 1% in 2008 and a further 4% in C The financial crisis The recovery in 2010 was short-lived, with the economy returning to recession for three quarters straddling 2011 and C This double-dip recession took place from 2011 Q4 (real GDP fell by -0.1%) through 2012 Q1 (-0.15) and 2012 Q2 (-0.4%). C

These have to be funded through the government issuing bonds, creating more national debt. C The problem with issuing more and more bonds to fund the budget deficit is that, over time, the level of national debt will grow. C This can be made worse if the confidence of bond buyers falls. C Sustained budget deficits This leads lenders to expect a higher rate of return to cover their perception of a higher risk of default. C And as the yield from government bonds rises, this puts upward pressure on borrowing rates throughout the economy. C The debt to GDP ratio for the UK is currently 75%. Despite austerity measures this ratio has more than doubled since C

A controversial study by Reinhart and Rogoff in 2010 argued that if the debt-to-GDP ratio in an economy exceeds 90% there will be a significant fall in economic growth, with subsequent implications for both GDP and public finances. C The paper argued that, without drastic action, as national debt reaches unsustainable levels, borrowing costs will rise and in extreme cases governments may be unable to meet their bond repayments and the country will effectively become bankrupt. C British Chancellor George Osborne called this Plan A – the implication being that there is no Plan B. C The rationale for austerity measures Since 2010 the coalition has pursued a policy of deficit reduction involving job losses across local and national government and a sustained programme of public spending cuts. C

This argument also makes the case for austerity, arguing that when the public sector is downsized this creates a more active and dynamic private sector. C Much as a larger state ‘crowds out’ entrepreneurship, a smaller state allows private enterprise to flourish. C This argument supports the neo-liberal ideology of free markets and small government, and echoes the classical macroeconomic model which predated Keynesianism. C Ricardian equivalence

Austerity measures can make worse the very problem they are seeking to address. C The UK and most countries in Europe have seen tax revenues decline and spending rise due to higher unemployment and the need to bail-out their own and other economies. C The impact of slower or even negative GDP growth on the public finances is known as fiscal drag or automatic stabilisation. C The problem with austerity measures 1

As economic activity falls, this reduces average income through higher unemployment, or pay cuts for workers who keep their jobs. C It also reduces wealth as the value of property and other assets falls. C And it decreases profits as firms are forced to reduce output or prices to stay in business. C The problem with austerity measures 2 Plus the newly unemployed, as well as no longer paying income tax, start to claim benefits. C Thus public spending rises at exactly the point in the economic cycle when the government can least afford it. C The appeal of austerity measures therefore depends on their ability to stimulate private sector spending by households and firms, and the credibility of the argument that high levels of debt damage economic growth. C

In terms of households, the UK saving ratio has remained above 7%, despite falling real incomes. C This is in contrast to an average level of 4% between 2000 and 2008, and reflects consumers saving as a precaution against further economic insecurity. C Consumer credit is growing at less than 3% per year in contrast to a remarkable average of just under 12% from 2000 to C Retail sales have grown by less than 1% per annum since the recession began. C Austerity: the outcome in the UK 1

For households and firms to fill the gap provided by a smaller government there must be reasonably high levels of consumer and business optimism. C Workers and consumers must be confident that jobs and incomes are stable enough to sustain higher levels of spending. C Firms must be confident that profits are not threatened by future economic crises. C But both consumers and service sector firms are less confident now, even compared to C Thus the idea of ‘Ricardian equivalence’ is simply not supported by the data. C Austerity: the outcome in the UK 2

The UK’s record on GDP growth since austerity measures were put in place has been poor. C Forecasts show that real GDP in the UK will not return to the levels experienced before the recession of until at least C Of course, the pro-austerity lobby would argue that without their deficit- reduction programmes, economic growth would be even lower and slower. C Austerity: the outcome in the UK 3 Some economists have argued that slow growth causes higher levels of debt. C In a major change of policy direction, the International Monetary Fund has warned that austerity measures have already damaged economic prospects in some economies. C

The relative merits of austerity programmes may perhaps only be fully understood with the benefit of hindsight. C The correct identification of cause and effect is a crucial issue in economics. C The pro-austerity case hinges on the extent to which deficit-reduction can stimulate growth and recovery. C Conclusion Critics of the measures argue that it is the austerity policies themselves which are causing economic stagnation. C In macroeconomic terms, the key argument weighs the impact of active fiscal policy against the effects of fiscal drag. C The data appears to suggest that austerity measures are not only failing to deliver growth to the economy, but also failing to deal with the budget deficit. C