Austerity

What is Austerity?

Austerity measures refer to government policies that aim to reduce public sector debt. Uncontrolled increases in a country’s public debt tend to increase financial instability within the country and can, if left unchecked, cause a national or even regional recession.

Austerity policies tend to increase unemployment within the economy and are generally unpopular with the electorate. Governments implement cost-reduction measures to demonstrate financial discipline to credit agencies and international lending agencies (such as the International Monetary Fund).

Examples of Austerity Policies

1. Increase in taxes

The government may raise taxes to increase its revenue. It can then use the additional tax revenue to reduce its debt. The government can choose to increase either the rate of direct taxes (income tax, wealth tax) or the rate of indirect taxes (consumption tax).

2. Decrease in government spending

The government may decrease its spending. The reduction in expenditure can be used to lower the level of government debt.

Austerity Policies in the Real World

1. The United Kingdom

The fiscal policy of the United Kingdom after the 2008 recession aimed to reduce government debt. Drastic reductions were made in public spending and taxes were increased to reduce the budget deficit. Although the National Health Service (NHS) and education sectors were blanketed from such cuts, the policy was severely criticized by both economists and politicians alike.

2. Greece

After the 2011 eurozone crisis, the EU forced the Greek government to implement austerity policies within the domestic economy. Before the 2011 recession, Greece ran a very large budget deficit. Under an EU directive, all non-essential government-funded projects were canceled. In addition, higher taxes were introduced across the country.

The Greek tax system underwent major changes, which eliminated many of the loopholes that previously allowed Greek businesses to evade taxes. Also, the country’s government services experienced a large reduction in administrative staff. The Greek government also sold off large public assets, such as state-owned buildings, to private citizens across Europe.

3. Spain

Spain also introduced austerity measures in 2011/12. The measures included increases in tax rates and a reduction in government spending. In particular, the Spanish government levied heavy taxes on the consumption of tobacco.

Advantages of Austerity Policies

The primary goal of adopting austerity measures into a country’s fiscal policy is to decrease government debt. However, many economists believe that austerity as a policy is ineffective, as reductions in government expenditure include cuts in welfare services, healthcare programs, and other essential government-provided services. In addition, austerity measures tend to affect low wage earners more than high wage earners.

Thus, the section of society that needs the most assistance during a period of economic instability is harmed the most by austerity-based policies. Proponents of such policies argue that the sustained increase in government debt can cripple the economy of a country. They view austerity measures as a necessary evil.

Theoretical Justifications Against Austerity

Classical Keynesian Theory developed in the aftermath of the Great Depression argued for increased government spending and reductions in taxes during recessions. The theory claimed that an economy could spend its way out of a recession. Anti-austerity measures would increase employment (especially in government services), which would, in turn, increase aggregate demand in the economy.

Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:

• Aggregate Supply and Demand
• Deflation
• Invisible Hand
• Monetary Policy
• See all economics resources