Austerity is based on the pro-cyclical fiscal policy; for the economy to experience a ‘boom’, government should spend more and reduce taxes but when the economy is in downturn, governments reduce spending and increase taxes. Austerity has been imposed in many countries following the recent global recession. Countries such as Greece and Spain, with huge public debts, are undertaking strong austerity measures.
However, there is a common misconception that high public debt was one of the causes of the recession and the public debt could lead to a bigger recession in the future. In actual fact, it was high private sector debt that was one of the contributing factors to the economic slump – public debt was merely a consequence. The key problem with austerity cuts lies in the aggregate demand of the economy. As the private sector begins to cut spending through wage cuts, redundancies, for instance, the level of demand in the economy falls because of consumer’s falling real income. This is where the public sector needs to step in and balance the economy out. However, if the public sector makes cuts as well, it creates a downward spiral in demand within the economy and worsens public debt. This has been seen in Spain and Greece, where instead of playing a stabilising role, the fiscal policy has ended up exacerbating the dampening effects of private sector cuts. Although running high deficits is not healthy from an economy, a country needs to aim to increase aggregate demand which will, over time, balance out the budget.
Stimulus measures aim to kickstart an economy through injections of money into the economy. This key Keynesian idea of a counter-cyclical fiscal policy has been used by governments since the Great Depression. Keynes claimed that the “boom, not the slump is the right time for austerity at the Treasury”. The concept of the stimulus package aims to increase consumer spending which, in turn, increases firm’s revenue and profit. As firms increase profits, they seek to expand thus creating new jobs and protecting the old ones. This entire system works together to create a robust economic cycle and most importantly, it leads to an increase in tax revenue for the government, which, in turn, reduces the deficit.
It is evident which fiscal policy works by looking at what the successful countries are using. The most prominent users of the stimulus policy are China and USA. They are both experiencing economic growth and over the long term, will be able to reduce their deficits through stimulus. On the other hand, countries in Europe and, that embrace austerity are witnessing high levels of unemployment, greater unwillingness for banks to lend and low consumer confidence.
Overall, austerity policies only target short term fiscal deficits and debt to GDP ratios, and as seen in Spain, it leads to exacerbated capital flight in countries that need demand. Stimulus policies, when implemented correctly and at the right time, can help reduce deficits far quicker than austerity could. Therefore, rather than follow pro-cyclical policies of the conservative economists, we need to embrace the counter-cyclical ones.
Contributed by Anurag Chandrasekhar