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Is austerity ever necessary?

Harry Young (Lower Sixth)

Congratulations to Lower Sixth pupil Harry Young who recently entered an economics essay into the 2021 Minds Underground essay competition and was 'highly commended' You can read Harry's essay titled 'Is austerity ever necessary?' here:

The issue of austerity, strict economic policies enacted by governments to reduce the budget deficit, has become a politically divisive one, particularly following the austerity programme initiated by Chancellor George Osborne in 2010, in the UK. Whilst this debate has focussed on the ruinous consequences of austerity if enacted at the wrong time, ultimately austerity measures are necessary at some point in the business cycle of an economy, albeit moderate measures. Focussing primarily on recent historical evidence from the UK and the Eurozone as case studies, in conjunction with a range of economic thought, this essay will elaborate on what the evidence suggests. Austerity is not just unnecessary but harmful in times of recession and recovery when Modern Monetary Theory should take precedence, yet nonetheless a necessity in times of rapid expansion to safeguard government finances, credibility and means of ensuring sustainable growth.

It is important to first understand the ostensibly desirable rationale behind austerity. These deflationary fiscal policies consist of cuts to government spending or increases in taxation to reduce the need for borrowing and allow the government to generate increased tax revenue to service debts. The primary objective of this is to reduce the risk of financial instability resulting from a sovereign debt crisis. Proponents of austerity need not look far to find such a crisis. In 1981, when Greece joined the European Union, it had a manageable debt-to-GDP ratio of 28% but the subsequent 34 years saw fiscal profligacy increase this to 175.9% in 2015, when it defaulted on its debt (Trading Economics, 2019). Triggered in late 2009 by the Great Recession, structural weakness in the economy and monetary policy inflexibility owing to EU membership, the fear of Greece defaulting resulted in a widening in the 10-year bond spread and ultimately the collapse of Greece’s bond market, as shown by Figure 1 (Trading Economics). Consequently, the cost of financing the growing deficit increased, resulting in a debt spiral and ultimately default. Herein lies one key justification of austerity: especially following a recession as experienced during 2008-2009, politicians are keen to curb public expenditure when deficits are high. The threat was particularly acute for Eurozone members who could not alleviate mounting debt by printing their own currency. “The austerian ideology swept all before it,” as economist Paul Krugman mused when referring to the subsequently swift adoption of austerity in Europe (Krugman, 2015). The maintenance of confidence in public finances (which attracts foreign direct investment and domestic investment whilst reducing the cost of borrowing) and the avoidance of a Greek-style crisis make a strong case for the necessity of austerity.

Whilst the imminent threat of crisis is certainly compelling so too is the evidence that contractionary fiscal policies can drastically restrict economic growth and widen inequality. In fact, textbook macroeconomic theory indicates that slashing government spending (a key component of aggregate demand) in a depressed economy, with scarce room to offset these cuts via reduced interest rates which are near-zero, would deepen the slump. The UK and other nations were already experiencing a severe negative output gap when David Cameron ushered in a new “age of austerity” (Cameron, 2009). According to Keynesian theory, as illustrated by Figure 2, a shock such as this to the economy which reduces already weakened aggregate demand (shifting AD leftward) can decrease growth of real national income, widening the output gap, and lead to unemployment (Pettinger, n.d.). Contrary to this, research from Harvard economist Alberto Alesina demonstrated the benefits of ‘expansionary austerity:’ fiscal policy changes in advanced economies between 1970 and 2007 showed that spending cuts were often “associated with economic expansions rather than recessions” (Alesina, 2010). Recent statistical data, however, has confirmed the long-established Keynesian view (at the expense of Ricardian Equivalence) that fiscal policy will be effective. Figure 3 plots the average annual change in the cyclically adjusted primary surplus (a measure of austerity) against the annual rate of economic growth for a number of countries, revealing a negative correlation (Krugman, 2015). Meanwhile, certain policies such as raising regressive taxes, like Value Added Tax, and cutting spending on welfare can increase income differentials in the economy. Evidently, the stage of the business cycle and the context in which austerity is adopted will heavily influence how necessary the policy is or indeed, in the case of post-2008 Europe, whether it is markedly unhelpful.

 

The threat to growth posed by austerity is reinforced by two further considerations. Firstly, note the position of Greece in Figure 3. In 1937, Keynes declared that “the boom, not the slump, is the right time for austerity,” and this is highly applicable to Greece (Blyth, 2013). Although deflationary fiscal policy should have been used to reduce the budget deficit when the economy was booming, the harsh austerity measures forced onto the country by the European Union and International Monetary Fund after the Great Recession (in return for €240bn in emergency funds) extracted a heavy toll on Greece. In 2011, they suffered a 6% fall in GDP which led to shrinking tax revenues, whilst debt-to-GDP continued to rise (Boyle, 2020). Austerity had hampered economic growth to the extent that the budget deficit did not improve. Secondly, research by Alesina and others has fallen out of favour in recent years. A review by the International Monetary Fund actually found that methods used in Alesina’s research to identify austerity produced considerable misidentifications (IMF, 2010). Further to this, the state of the money supply is also consequential to the aforementioned research. When Canada, for example, reduced fiscal expenditure from 1993-1996, the Bank of Canada was able to mitigate the effect of austerity with dramatic rate cuts and hence the necessity of austerity was, again, determined by context. It can be concluded from these examples that austerity can be applied in a pre-existing high interest rate environment or booming economy but, in other situations where these policies have been deployed, austerity has proven fatal.

More recently, the Covid-19 pandemic has forced the government to rack up huge debt to prop up the economy, a feat some would argue was made possible by previous cuts in the budget deficit. Flexibility in government spending, when necessary, is an important aspect of austerity. By saving surplus revenue from austerity policies, governments can keep aside fiscal firepower for emergency use or future improvements in the state of the economy. As a result, there is room for expansionary fiscal policy in a recession to put the economy back to full employment. In their 2010 paper ‘Growth in a Time of Debt,’ Carmen Reinhart and Kenneth Rogoff stated that 90% debt-to-GDP is the critical threshold beyond which growth rates plummet (Rogoff, 2010). Thus, when Covid-19 ravaged the economy, the UK government was able to spend £407bn on pandemic support, starting from a debt-to-GDP ratio of around 85% which had levelled of after a sharp rise in 2008-2009 (ONS, 2021). Although this was high relative to the last 50 years and has since exceeded the 90% threshold, it can be inferred that the government finances would now be in a significantly more perilous situation had austerity measures not caused the debt levels to plateau in the preceding 5 years, as shown by Figure 4 (ONS, 2021). If the budget deficit is unsustainable, the long-term impact of expansionary fiscal policy could be severe austerity at a time when it would have an extremely degrading impact. In this instance spending cuts are desirable, not to reduce the burden of previous debt, but to accommodate future spending rises when they are really needed. Austerity is necessary but the timing is crucial.

 

Finally, it is hard to ignore the low interest rate environment in many developed economies and the implications of Modern Monetary Theory (MMT), which do not demonstrate the harm of austerity but question its necessity. Originally theorised by American economist Warren Mosler in the 1970s, MMT developed into a macroeconomic framework that says monetarily sovereign countries are not restrained by deficits (Mosler, 2020). Instead, they can freely spend with the ability to finance this by printing their own fiat currency; the government, after all, are the monopoly issuers of that currency. This is not an insignificant insight. To illustrate, former chairman of the Federal Reserve Alan Greenspan famously noted that “there’s nothing to prevent the federal government creating as much money as it wants” (Greenspan, 2005) In fact, in 2009, when Ben Bernanke was interviewed on CBS’s 60 Minutes, he revealed that the federal government’s $1trn bailout of the banking system in the wake of the 2008 financial crisis was “effectively” printed, stating that “it’s not tax money” (Bernanke, 2009). Importantly, the bailout was not followed by high demand-pull inflation, as would be indicated the Quantity Theory of Money. A further example can be seen in Japan which runs a deficit of 240% of GDP, and yet had an inflation rate of 0.48% in 2019. Furthermore, if stimulus is introduced when interest rates are rock-bottom this should allow an economy to grow its way out of debt because it is relatively inexpensive to service this, albeit high, debt. In late 1940, UK public sector debt-to-GDP was nearly 150% rising to over 200% by 1950 when the post-war Labour government set up the Welfare State and the NHS (Pettinger T. , 2016). Instead of the economy buckling under this debt, bond yields stayed relatively low and the post-war economic boom drastically increased GDP thereby reducing the debt-to-GDP ratio (again refer to Figure 4). This evidence would suggest that as long as a country can print its own currency and interest rates stay low, an economy can use expansionary fiscal stimulus to grow its way out debt and not suffer the consequences of inflation or crippling debt repayments.

The conclusion here is very much akin to a quote by Stephen Schwartzman, co-founder of Blackstone, when referring to the housing boom in America: “when the market was going too fast they slammed on the gas. When it was grinding to a halt, they hit the brakes. The poor consumer suffered whiplash in the passenger seat” (Schwarzman, 2019). Although referring to a different context, the analogy can warn of the dangers of austerity measures when the economy is “grinding to a halt.” In this scenario, there is a negative output gap, weak aggregate demand, low interest rates with little room to move, spare capacity among factors of production and scarce sign of inflation. Naturally, this should be the time to “slam on the gas” and use low interest rates and the implications of Modern Monetary Theory to fuel a government-led recovery, whereby the multiplier kicks in and the economy out-grows its debt. Recent empirical data tells us this much. The crux of the argument, however, lies in the fact that sustainable, long-run growth and investment (the engine of this growth) partly rely on confidence and sound public finances. It can be concluded that moderate austerity is necessary, when the economy can afford it, to avoid a Greek-style debt crisis and instil confidence in the economy, whilst reducing the deficit for the future. If the structural deficit is persistently high, the long-term impact of expansionary fiscal policy could be severe austerity at a time when the economy really cannot afford it. Printing money is one instrument to use but it is important not to forget the real goods, services and factors of production that it is spent on and the limit placed on spending by inflation. Austerity, therefore, is an unwelcome feature of government policy but one that can be necessary to protect the consumer “from whiplash in the passenger seat.”

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