Download Andrew Threadgould, Dulwich College

Are austerity measures
self-defeating?
Andrew Threadgould, Dulwich College
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Austerity measures
• C 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.
Government budgets have been a particular problem since
•C
the recession of 2008-09.
When a government has a budget deficit this must be
•C
funded using either money from previous budget
surpluses or through issuing bonds.
Keynesian macroeconomic
management policy
• 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 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.
Keynesian policies
under pressure
• 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 Despite the period 1997-2007 being generally one of strong GDP growth,
from 2002-03 onwards the budget was in deficit every year.
The financial crisis
• C The impact of the financial crisis of 2007-08 and the subsequent recession
across Europe and North America led to a sharp increase in the deficit in
2008-09.
• 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 2009.
• C The recovery in 2010 was short-lived, with the economy returning to
recession for three quarters straddling 2011 and 2012.
• 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%).
Sustained budget deficits
• 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 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 2008.
The rationale for
austerity measures
• 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 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.
Ricardian equivalence
• 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.
The problem with
austerity measures 1
• C 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.
The problem with
austerity measures 2
• C 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 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.
Austerity: the
outcome in the UK 1
• 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.
• CConsumer credit is growing at less than 3% per year in contrast
to a remarkable average of just under 12% from 2000 to 2008.
• CRetail sales have grown by less than 1% per annum
since the recession began.
Austerity: the
outcome in the UK 2
• C 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 2008.
• C Thus the idea of ‘Ricardian equivalence’ is simply not supported by the
data.
Austerity: the
outcome in the UK 3
• C 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 2008-09 until at least 2015.
• C Of course, the pro-austerity lobby would argue that without their deficitreduction programmes, economic growth would be even lower and
slower.
• C 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.
Conclusion
• 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 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.