Understanding Austerity, Types of Austerity Measures, and Examples

What Is Austerity?

The term austerity refers to economic policies implemented by a government to control public sector debt. Governments use austerity measures when their public debt is so large that default or the inability to make necessary payments becomes a real possibility.

The goal of austerity is to improve a government’s financial health. As debt levels increase, lenders charge higher interest rates for future loans, making it difficult for the borrower to raise capital.

Key Takeaways

• Austerity refers to economic policies imposed by a government to control growing public debt.
• There are three primary types of austerity measures: revenue generation (higher taxes) to fund spending, raising taxes while cutting nonessential government functions, and lower taxes and lower government spending.
• Austerity is controversial, and the outcomes can be damaging.
• Many countries, including the United States and Greece, have implemented austerity measures during economic uncertainty.

How Austerity Works

Governments experience financial instability when their debt outweighs revenue, resulting in large budget deficits. Debt levels increase when government spending increases. This increases the risk of default on debts, leading creditors to demand higher interest rates. Austerity measures are taken to control debt levels and satisfy creditors.

Austerity is implemented when the gap between government receipts and expenditures shrinks. This occurs when a government spends too much or takes on too much debt. Governments consider austerity measures when they owe more money to creditors than they receive in revenues. Implementing these measures restores confidence in the economy and helps balance government budgets.

Creditors may lower interest rates on debt when austerity measures are in place. However, the benefits are often limited and primarily affect large corporations rather than consumers.

Special Considerations

A reduction in government spending is not always austerity. Governments may implement these measures during certain economic cycles.

For example, during the global economic downturn in 2008, many governments faced reduced tax revenues and unsustainable spending levels. Austerity became necessary to address these budget concerns.

Austerity was particularly imperative in Europe, where some countries did not have the ability to print their own currency. Creditors pressured these countries to aggressively tackle spending as default risk increased.

Types of Austerity

Broadly speaking, there are three primary types of austerity measures:

• Revenue generation through higher taxes: This method supports more government spending and aims to stimulate growth and capture benefits through taxation.
• The Angela Merkel model: Named after the German chancellor, this measure focuses on raising taxes while cutting nonessential government functions.
• Lower taxes and lower government spending: This is the preferred method of free-market advocates.

Taxes

There is disagreement among economists about the effect of tax policy on the government budget. However, most agree that raising taxes increases revenue. Many European countries increased taxes during times of austerity.

Reducing Government Spending

Reducing government spending is considered an efficient means of reducing the deficit. Austerity programs may include measures such as cuts or freezes in government salaries and benefits, freezes on government hiring, reductions or eliminations of government services, cuts to government spending programs, and increases in taxes.

Criticism of Austerity

The effectiveness of austerity is a matter of debate. Supporters argue that deficits can harm the economy, limiting tax revenue. Opponents claim that cutting government spending leads to unemployment and argue for increased government spending during recessions.

Examples of Austerity

United States

A model of austerity occurred in the United States between 1920 and 1921. President Warren Harding implemented federal spending decreases and tax cuts to fight the recession. However, economists and historians debate whether these measures were necessary or can be considered austerity measures.

Greece

Greece implemented austerity measures in exchange for bailouts after the Great Recession. The program cut public spending and increased taxes, but it provided mixed benefits to the economy.

What Is a Budget Deficit?

A budget deficit occurs when spending exceeds revenue. Governments must borrow money, increasing the country’s national debt.

What Happens When a Country Defaults?

Sovereign default occurs when a country cannot pay its debts. Default can cause economic problems, such as triggering a recession or devaluing the country’s currency. Defaulting can also make it difficult for a country to borrow money in the future.

Do Austerity Measures Work?

Economists disagree on the effectiveness of austerity measures. Supporters argue that austerity is effective in reducing deficits. Opponents claim that government spending is necessary to lower unemployment and increase tax revenue.

The Bottom Line

Austerity measures are strict economic policies used by governments to manage public debt. They can take various forms, and their effectiveness depends on the overall economic situation.