The Two Types of Austerity Therapy

The Two Types of Austerity Therapy


by Carlo Favero, Dept. of Finance, Bocconi
Translated by Alex Foti

The term austerity indicates an economic policy aimed at stabilizing or reducing the debt/GDP ratio for a given national government. There is no economic justification for a growing trend in the debt/GDP ratio. It is theoretically correct to manage public finance in a countercyclical manner, in doing so alternate deficits in phase of contraction and growing surplus, avoiding the generation of a positive trend of growth in the debt/GDP ratio.
Economic theory essentially suggests two cases in which governments should do deficit spending: during recessions, to cushion the negative effects on growth, and in exceptional circumstances, such as wars and natural disasters. These deficits should then be followed by budget surpluses when the economy goes back to growing and spending needs are low. Therefore optimal fiscal policy is compatible with temporary debt but not with permanently growing debt.

High and growing debt has no economic rationale but has political motivations linked to the propensity of governments to conduct irresponsible fiscal expansions (because they are not followed by fiscal adjustments) leaving the burden of responsible behavior (i.e. counter-cyclical adjustment) to future governments. The reason is simple; creating deficits and distributing resources is popular with voters, while future generations, being too young or unborn, cannot vote.

The data on the effects of austerity policies, however, tell us that that the fierce discussion that has engulfed much of the West has not focused on the fact that austerity is twofold. In fact, there is a huge difference between macroeconomic adjustment based on tax increases, which are very painful and not very effective, and adjustment based on spending cuts that are much less costly in terms of curtailed growth and much more effective in terms of stabilizing the debt/GDP ratio.

When debt becomes too high, austerity becomes a necessary cure. By studying a database made of 170 long-term fiscal adjustment plans conducted by national governments in 16 OECD countries between 1970 and 2014, we have evaluated the effects of the two different ways of administering the treatment, and what emerges points to shifting the terms of the debate from an ideological discussion between the pro-austerity and the anti-austerity fronts, to an analysis of the consequences for growth of the two different types of austerity. The study of the data reveals that expansionary austerity (i.e. of an austerity that produces growth as a consequence of the reduction of the uncertainty caused by a lowering of the debt) is not present in the data, which instead highlight the significant difference for growth between stabilizations based on tax increases and stabilizations based on spending cuts. Increasing taxes has a strongly recessive effect on growth and does not lead to stabilization of the debt/GDP ratio, while cuts in government expenditure have on average a slightly recessive effect but stabilize the debt/GDP ratio.

A clear example is the case of Ireland in 2009, when the Irish government acknowledged the perverse effects of the tax-based austerity package and revised its policy with a successful macroeconomic stabilization based on spending cuts.

High debt is a symptom of irresponsible past governments, thus the answer to high debt cannot but be a return to responsibility. When debt becomes too high and has a growing trend, responsibility requires austerity and the implementation of austerity requires enlightened politicians who are cognizant of the heterogeneous effects of different stabilization policies.

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