Expansionary Austerity – How does it work?

Austerity refers to a reduction in Government Expenditure, (G). It is a measure used to reduce the budget deficit of a country. Austerity measures have been implemented in many regions of the world, such as in debt-ridden European countries and in the United States. Austerity has also been argued to be capable of boosting the Economy in the aftermath of the Global Financial Crisis. But how on earth can reducing (G) result in expansionary effects in the Economy?

This phenomenon is known as Expansionary Austerity. It works through an increase in the confidence levels of Households and Firms. The increase in Confidence level works though two main channels: Firstly, Austerians argue that Austerity leads to a decrease in Budget Deficit, which lowers expectations about future government borrowing. This leads to a decrease in future interest rates as the future demand for loanable funds falls. Interest rates fall, and this encourages firms to borrow more as the cost of borrowing has fallen. As the returns to Investments increase, firms increase their Investments, which contributes to an expanding economy. Secondly, by lowering (G), expectations of future taxes falls, reducing the burden of taxes on the economy. This leads to an increase in Disposable Income (Yd) and an increase in Consumption, (C). Therefore, austerity measures seem to be capable of boosting Aggregate Demand in the economy. 

In summary, Expansionary Austerity works provided: 

Increase in (C) + (I) > Decrease in (G)

However, statistics have highlighted time after time that the effects of Austerity are largely contractionary, rather than expansionary. This gives rise to the term Confidence Fairy, which Krugman argues rarely appears to give the Economy the much needed boost for the increase in (C) and (I) to outweigh the decrease in (G). Hence, Expansionary Austerity does not work that effectively as it involves a negative variable that reduces the net effectiveness of such measures in boosting AD. 

In addition, while the main aim of Austerity is to reduce the budget deficit and fiscal debt in the economy, its contractionary effects could ironically increase the real value of debt. This is because a shrinking economy could potentially lead to deflation, resulting in a greater burden of real debt. Thus, austerity measures may not be that great at solving the issue of high debt and an overwhelming budget deficit. 

  • Paul Krugman – End this Depressiom Now! 

Austerians also argue that countries with high debt should tighten their belts just like how debt-ridden households reduce expenditure to pay off their debts. This analogy is of course, flawed as the economy does not work in the same way as a household. In the economy, assuming all debts are domestic, one person’s debt is another person’s income. Therefore, comparing a debt-ridden household to an economy with high debt is certainly not a fair comparison. Some Austerians also regard Austerity measures as a form of moral punishment. They wish to punish debt-ridden countries such as Greece for having such unsustainable levels of government spending previously which resulted in a huge budget deficit. This argument rarely makes any economic sense, and is largely invalid as punishing the economy by prolonging unemployment does not solve the root cause of the issue, that is uncompetitiveness and a lack of fiscal integration in the case of the EU. 

Finally, the argument about bond vigilantes who dump the stock market when a country’s debt is excessively high, is also exaggerated and untrue. This is because countries such as Japan and the United States, who have much higher debt (to GDP ratio) than Greece, have not been attacked by these so called bond vigilantes who would dump a country’s stocks due to a loss in confidence in the country’s economy.  

In conclusion, the arguments for Austerity measures as a means of boosting the economy are largely invalid and flawed. While it may be a theoretically plausible solution, it has been proven to be ineffective in many instances and has prolonged the recession, rather than alleviate it. 


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s