Austerity: the Right Medicine?
Lebanon currently faces a nefarious financial crisis. Moody’s estimates the government’s domestic assets to be valued at around $10 Billion, which shies in the face of maturing debts and a budget deficit of 11.5% of GDP. As politicians scramble to international conferences and debate conditions on mitigatory loans, the lenders have the usual elephant of a reply—austerity!
The idea is almost obvious. In order to assure lenders of return, the borrowing nation must put into place economic reforms which decrease deficits, usually by cutting public sector spending and increasing tax revenue. Perhaps the most famous case of these measures was the Greek debt crisis of 2009. In order to secure bailouts from European banks and the IMF, Greece had to accept strict ‘austerity packages’ which involved actions such as setting limits to public employee bonuses, heavily increasing Value Added Tax, and decreasing pension payments. These measures would be considered worthy of the loans—if there would be a resulting fall in the budget deficit and eventually a stable balance sheet and inflation level. That never happened. In fact, looking as the history of public finance, austerity has hardly ever worked the way borrowers want it to.
The first reason why austerity is not considered a suitable response to public debt crises is more of a social and moral one. Massive public debt oŌen entails rising prices due to quantitative easing and low industrial growth. An already difficult life is doubled down on when budget cuts, bonus and pension reductions, high taxes on imported goods, and usually any other austerity measures come rolling in. The same way the Greeks took to the streets when pensions were reduced, the Lebanese Prime Minister met the fury of his people when he attempted to implement a tax regime, including taxes on WhatsApp and Messenger calls. The protesters complained that the crisis, a result of corruption and mismanagement, was being balanced on the shoulders of ordinary hard‐working citizens.
Beyond the moral reason, there exist macroeconomic counters to the performance of austerity packages. Large spending cuts and tax hikes constitute most of these packages. However, in the name of financial health, a fall in government spending is oŌen paired with shrinking aggregate demand in the economy. This, according to the classical Keynesian theory, is exactly what the government should fight to prevent. Several macroeconomists argue that a lack of stimuli is far worse than the some of it, even at snail‐like pace. Consider the differing responses to the 2008 financial crisis by the UK and the US. In light of the IMF suggesting a 2% fiscal stimulus package, the US government heavily cut taxes for the middle class; and, initially, so did the UK. However, as a new government took power in the UK in 2010, economic policies turned stringent and austerity‐centered. The goals of both nations were the same—become financially stable again and gradually raise real output. As shown in the graph (on last page), the UK’s policies ended up much less effective.
Apart from reduction in real output and a dip in employment, these cuts lead to two major concoctions of economic demise—tax revenue reductions and heavy deflation.
Consider the case of Japan’s Lost Decade—a period of economic stagnation in the 1990s. It has become a classical example of misguided economic policies by the government. Due to marginal improvements by fiscal stimuli, the Japanese government decided to employ austerity instead to manage their debt. As this entails both low aggregate demand and high taxes, Japan was essentially taxing a shrinking economy. Austerity measures oŌen counteract one another on either side of the balance sheet. The run‐off problem of deflation is also related to how the economy, specifically the private sector, reacts to an already gloomy economic atmosphere.
Economist Richard Koo observed this bewildering phenomenon in post‐asset bubble Japan—despite real interest rates approaching zero, private sector debt was decreasing instead of increasing. This implies that net savings of industries and financial institutions were rising. Koo termed this a “balance sheet recession.” In post‐bubble economies, private players fear sudden bankruptcy and tend to pay off debt rather than taking more on. The increase in net savings in a time when the government is drowning interest rates creates a deflationary gap, and a recession looms. The only way to escape this is rejuvenating fiscal stimuli, which is held at bay by austerity policies.
So, is austerity entirely useless? Not quite either. Austerity certainly helps restore financial stability, but it must be carefully targeted and timed. Tax hikes and spending cuts must focus on temporarily expendable areas. For example, in the case of India in 1991, tax hikes focused exclusively on luxury goods while tax deductions for most of the economy shot real output and the government quickly coffered up. Furthermore, if there has to be blanket tax hikes and spending cuts, an emphasis must be placed on sustaining government operations over payment of debt. Despite most of Greece’s initial austerity measures aiming at loan repayment, Greece found itself in a debt trap due to a shrinking economy and turbulent public reactions. Thus, as Lebanese politicians bargain over interest rates for mitigatory loans, they must keep in mind the shackles that austerity brings with it.
Written By Akhil Rastogi, Undergraduate Economics Student
1. https://www.reuters.com/article/us‐lebanon‐economy‐crisis/lebanon‐pushed‐to‐the‐brink‐faces‐reckoning‐ over‐graft‐idUSKBN1WX2CF
2. https://www.ncbi.nlm.nih.gov/pmc/articles/PMC4952125/
3. http://www.cnn.com/2008/POLITICS/02/13/bush.stimulus/
4. https://www.ft.com/content/710bdd68‐540b‐11e1‐8d12‐00144feabdc0
5. https://knowledge.wharton.upenn.edu/article/does‐austerity‐work‐or‐does‐it‐make‐things‐worse/