Government debt in many countries has already grown beyond sustainable levels. In the US, the federal government routinely runs trillion-dollar deficits and is headed towards a fiscal cliff of severe economic decline even before the banner of the Green New Deal was raised. When the next recession does hit the US, it could result in a significant decline in GDP and this will result in lower revenue for the government and increased expenditures for things like welfare and unemployment benefits.
Another related concern is a rise in interest rates which would significantly increase the amount of interest payments on the national debt. If both a recession and higher interest rates were to occur simultaneously, which seems likely, austerity policy could be a necessity. Central to their analysis is the distinction between austerity plans that rely mostly or wholly on tax increases and austerity plans that rely mostly or wholly on cuts in expenditures. They find that tax increase-based plans, i.
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In contrast, they find plans that are expenditure reduction-based plans, i. This finding invalidates the Keynesian complaint that government spending cuts reduce aggregate demand and causes deeper recessions. The main reason the Keynesian view is invalid is that credible spending cuts give entrepreneurs and investors confidence that no tax increases will occur in the future.
Immediate and planned spending reductions are a signal that taxes will be lower, or at least not higher, in the future and this is good for the economy. Chapter 3 provides several case studies of countries that have employed TB or EB plans and what they experienced. Several countries adopted austerity measures in the early s. For example, Belgium had a budget deficit of In response, authorities announced a multi-year austerity plan that cut spending the equivalent of 6.
The economy contracted in and then turned positive, reaching 4. In contrast, between and Ireland adopted an austerity plan based almost entirely on tax increases. Nearly every aspect of the Irish economy experienced higher taxes totaling almost 7 percent of GDP. As a result, the economy remained sluggish, the deficit was not reduced, and the debt to GDP ratio increased from 74 percent to percent by In , Ireland adopted a new austerity plan based entirely on spending cuts and the economy quickly recovered.
This chapter is by itself worth more than the price of the book.
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Comparing TB and EB plans in Chapter 7, the authors find EB plans are better than TB plans in terms of output, consumption, and much better, as we would expect, in terms of investment. Also, as we would expect, EB are superior to TB plans in terms of consumer and business confidence. In terms of EB plans, plans based mostly on cuts in transfer payments and those based mostly on general cuts in government spending are both superior to TB plans.
The authors try to weed out the impact of other policies and aspects of austerity plans. So, they examine the potential impacts of money policy, exchange rate movements, and structural reforms in labor and product markets, e. They also find that EB plans were far superior to TB plans in terms of reducing the debt-to-GDP ratio, a primary reason for austerity plans in the first place. In chapter 8 the authors examine the impact of austerity in the post Financial Crisis. Their result that EB plans are superior to TB plans is sustained, but the authors caution:. One should keep in mind that fiscal policy was not the only player in the field: banking crisis, collapse of confidence, the credit crunches also played a role.
It would be simplistic to attribute everything that happened in Europe between and only to fiscal policy. Chapter 9 addresses the question of how the state of the business cycle, i. Chapter 10 addresses the impact of austerity plans on reelection bids and whether they are necessarily a political kiss of death normally they are not. This is an important book with consistent results favoring EB austerity plans over TB austerity plans in terms of both current output and the national debt.
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Narrative approach discussed. Concise Encyclopedia of Economics. Gregory Mankiw. Ramey on Stimulus and Multipliers. October Reinhart and Kenneth S. January Carmen Reinhart on Financial Crises. March What does the "burden of the debt" refer to? August David Ricardo. A few more EconTalk podcast episodes: Time is Money. Feature EconTalk Extras Complementary questions for further thought and discussion on this episode. Jonathan Haidt on the Righteous Mind. Start at for the discussion of austerity and confirming moral biases. Noah Smith on Whether Economics is a Science.
Time Podcast Episode Highlights. More EconTalk Episodes. But it's an issue that a lot of people are very interested in; it's an issue that has been in the news as well as the economic conversation for the last, really, 5 years, with a lot of intensity. So, I want to start with this seemingly simple question, which is: What is austerity? Guest: Austerity [? But the way I think of austerity is a situation in which, for whatever reason, fiscal policy--budget deficit, government debt--have gotten sort of out of hand in the previous years.
And for whatever reason it is decided that now is the time to return to a more rigorous fiscal policy, and reduce the deficit, reduce the growth of debt. In principle, there should never be any need for austerity if government followed the rules of optimal fiscal policy--namely, having deficit during recession or in period of exceptionally high government spending needed for a war or for a natural calamity or whatever; and then having surpluses during booms and periods in which government spending is not high, is not especially high. So, if the government followed these optimal fiscal policy rules, there would never be any need for austerity.
Austerity comes about when, for some reason, government has gone out of whack and they increase debt and deficit too much.
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Or, there were a combination of, say, a financial crisis and government not having had [? So, the point of what I'm trying to make is that austerity is something that should be considered as something out of the ordinary, something that happens occasionally when government has done something wrong in the past. Russ: You can think of it as, it's described, it's talked about, I think, in two different ways in the press. Which is: Austerity--some people paint it as a strategy: 'Well, we're not doing very well. The economy is not doing well. We need to do something; and we should cut spending, or raise taxes; cut the deficit as a way to engender confidence.
I think sometimes you hear it from the critics rather than the supporters of austerity. But that's one story. The other story is: 'We don't have a choice. We're going to have a crisis, and so we're going to have to do something dramatic to return to fiscal sanity. Do you hear them talked about? Do you hear austerity talked about in those two different ways? Am I right? Guest: Yes. I mean, I would say there are even more than two different ways. But certainly these are two of the different ways.
I would say, there are many reasons why an economy may not be doing well. I'm talking about the first avenue: There are many reasons when an economy may not be doing well--excessive deficit and excessive public debt is of course one of them. And there are reasons to believe that if, say, government spending is very high, taxes are very high; and the theory is that these are creating a burden on the economy, and therefore you need to do something about that.
That's one view about the [? And that has happened--before the financial crisis, there have been many, many, many cases, many examples of austerity exactly along those lines. Countries failed like they were in a difficult situation, partially due to fiscal imbalance and the need to do something about it. Sooner or later they needed to do something about it. And in fact, the more they waited, the more costly would it be to engage in these policies. As you said, the second type of austerity is one in which we are in a crisis: for whatever reason, the market doesn't believe in us any more.
And there is nothing else we can do. And then of course there have been several examples of those after the financial crisis. And in some cases, there was no choice. Let me say that, the one interesting aspect of this is, when you have no choice and you have to do something quickly, in most cases it is actually much easier to raise taxes, because you have an immediate effect on the budget. Just ask people: Go to the cash machine of the taxpayer, and you get money out of them.
To cut spending: Figure out what to cut, how to cut, how to do it. A perfect example with my own country of origin, Italy, is that in , and , was in a situation of being close to default on the debt because the interest rate went through the roof. There was contagion from Greece. The previous government, the [? They had to do it quickly, and the only thing they could do was to raise taxes. The result was another major recession in Italy. So, sometimes the time pressure makes you make the wrong choices about which kind of austerity to do.
Russ: And in a little bit, we are going to talk about that different choice between raising taxes and cutting spending as a way to close the deficit and bring about a balance and to reduce the need to borrow. Russ: But, I brought up those two examples--the sort of strategic idea of austerity versus the 'Oh, my gosh, we have to do something' view--because I think I've found it fascinating that after Greece, which got most of the attention in its crisis, a lot of people said they made a huge mistake in trying to close the deficit.
They needed, in fact, to be borrowing even more. And what would you say to that claim? Guest: I think Greece is a special case. To begin with, they were growing and [? It turned out that they were doing it just because they were borrowing and consuming what they were borrowing. Because Greece had sort of hidden their deficit. There was major tax evasion. Productivity was not growing; it was actually declining.
It was a country in complete economic disarray. Now, at that point, probably the cleanest solution would have Greece default, and call it a day. The problem was that--it was that Greece is also a very small country relative to the rest of Europe. The problem was that--well, the cynical view is that the German and the French did not want their banks to suffer from a Greek default, because German and French banks held a lot of the Greek debt.
The less cynical view would be that the default in Greece would have triggered contagion in other high-debt countries, like Italy, or high deficit countries like Spain and Portugal and Ireland, that may have created a second major financial crisis, perhaps even collapse of the Euro.
What Economic Research Says About Fiscal Austerity and Higher Tax Rates
So, the austerity plan for Greece was, in my opinion, not credible. Nobody really believed, I think, that it would have worked [? And in fact they were not. They tried [? And so, going back forth. And then the worst[? So Greece was completely mismanaged. And there was a sense that if the market completely stopped believing in the ability of the sustainability of these countries' debt, particularly the debt of Italy which is really large, there would be a major, major, major disaster with the bank [?
And perhaps collapse of entire financial institutions of Europe. At that point, to simply say 'We need to borrow even more because we need to support the economy to grow more to get out of the recession,' it was, in my opinion, somewhat short-sighted, in the sense that to simply think about government spending more to get the economy more quickly out of a recession was in my opinion forgetting all of these other aspects, which were a problem of potential financial collapse, bank failures; and then a new and much bigger recession.
So, Europe, for all this combination of reasons, European countries were forced to enter in this austerity policy probably sooner than might have been optimal. Some countries had accumulated too much debt before the financial crisis. So, they were in a situation in which they could not [? So they entered in a phase of austerity, perhaps attached too soon than they should have.
And , it seemed they were forced by these market forces, they had to do something quickly. And in some cases--not all cases--they ended up raising taxes than cutting spending. But even when you look carefully at the data, once again you find that austerity done by raising taxes has been austerity done by cutting spending.
Even after the financial crisis. Russ: So, let's talk about that. So, your work focuses on many issues. But that one in particular is one I think is the most interesting. Which is that when you studied this recent episode of European countries trying to reduce their deficits, you found a very different response for the economy as a whole when those changes were done via tax increases versus spending cuts.
Try to summarize the range of magnitude and the differences in the two responses. Guest: Okay. So, before the financial crisis, after the financial crisis, there were several papers that I and others had written which had found that, in a way which, in my opinion, is pretty much uncontroversial--people may disagree about the magnitude of this or that coefficient--but any unbiased observer would agree that after the financial crisis, all the episodes of austerity after then were characterized by the fact that those that were based on government spending were much less costly to absorb[?
In fact, in some cases government austerity done with cut in spending [? And in some cases, there have been also cases called expansionary austerity, namely the budget cuts, spending cuts have been associated with an increasing growth rather than declining growth. While tax-based austerity has been much more costly. And the differences are quite large. So very large, very large differences. And we can return, then, to that--we can go into more detail later.
Now, when the financial crisis occurs and the austerity that followed the financial market happened, there was a period in which some of the--everybody said, 'Oh, look, austerity is terrible. It is causing recession. It's a disaster. Look what's happening. And let me give you two examples. While other countries were coming out of the recession in and , Italy was still deep down in the recession, as it is now, to this tax [?
The opposite example is England. When the Cameron government came into office, it announced, it implemented spending cuts, in and so--and in fact it is interesting that the IMF International Monetary Fund predicted a major recession for Britain. And there was quite a vocal disagreement between the British government and the IMF about the benefits and costs of their spending cuts.
And in the end we discovered them not to be right; and in fact the IMF apologized publicly for having under-predicted the United Kingdom economy, who did quite well in , , On average they did well. They did not enter in a recession. And they reasonably well. Quite well considering that they were still suffering from the Financial Crisis [of ] and they had done pretty sizeable spending cuts.
Russ: Did they actually cut spending? Or did they just talk about it? Guest: Well, that's a good question. There was a lot of talk about it. Say, they talked, and they announced 10, and then they did 4 rather than But they certainly did something. And the deficit did go down substantially. The public debt slowed it's growth.
So, they talked more than what they did. But they did do something. So, yes, there is a sense in which they--even though, I must say that incidentally--and this is actually another quite interesting point: The announcement of policies may actually have an effect on the economy as well. Russ: Fair enough. Guest: So we may need [?
But in any case, they certainly did less than what they were saying; but they did indeed do something. Russ: I just have to quote--I have to give you two quotes here. One is from Paul Krugman, in November of And the second is Paul Krugman in April of Here's the first one: The doctrine of expansionary austerity--the proposition that cuts in government spending would actually cause higher growth despite their direct negative impact on demand, thanks to the confidence fairy--was all the rage in policy circles five years ago.
But it brutally failed the reality test; instead, the evidence pointed overwhelmingly to the continued existence of something very like the old-fashioned Keynesian multiplier. The second one is even more pointed: Meanwhile, all of the economic research that allegedly supported the austerity push has been discredited. Widely touted statistical results were, it turned out, based on highly dubious assumptions and procedures--plus a few outright mistakes--and evaporated under closer scrutiny.
It is rare, in the history of economic thought, for debates to get resolved this decisively. The austerian ideology that dominated elite discourse five years ago has collapsed, to the point where hardly anyone still believes it. Hardly anyone, that is, except the coalition that still rules Britain--and most of the British media.
Is he talking about your work? Being "discredited"? Or do you think--or is there something orthogonal about that claim to your work? Is there something that--is he talking about some different aspect? Because he makes it sound like this view that cutting spending-- Guest: Well, I think Paul Krugman has rather extreme views.
But more importantly, he talks about his views as if they were obviously true, and anybody who would disagree with him was obviously wrong. And he exaggerates. And that I really prefer not to go into a discussion about his quotes.
But I think that the idea that the work about austerity that I and others have done has been discredited is wrong. In fact, the IMF, in wrote a rather pointed criticism about my work, in particular about two points: one, whether spending cuts were less much less costly than tax increases in terms of austerity policy.
And when everything, after everything was said and done and written, even the IMF acknowledged--had to conclude that this was indeed the case: that spending cuts were much less costly than tax increases. Now, the reason that not completely clear to me they seemed to underscore this message of their own work was, if you read the published paper of this IMF research, you will conclude that they also agree with this conclusion. Which is the fundamental result about austerity, on which my work is based.
So on this point, actually, I think Krugman is completely wrong. I think there is uncontroversial evidence that spending cuts are much less costly than tax increases. Russ: So-- Guest: And this point is exactly the opposite. Now, the second point is whether there are cases where spending cuts accompanied by other policies can be expansionary, and the confidence argument that he makes fun of is actually confidence, one of the many aspects; and we can elaborate on that.
But I think that there are several episodes in which fiscal spending cuts have been accompanied not by a recession, but by an expansion. So, I think that those kind of statements by Krugman are trying to push a view which is respectable but they are not proven by the facts. Or at least they are not supported by research. Russ: So, let's talk about the empirical finding itself, and some of the challenges of measuring it.
But I want to start with the intuition, if there is any, in the most basic Keynesian model of the role of government spending. It's not a model I'm a particular fan of, but it's the one that I think most students are taught, as undergraduates, still. Government spending, in a recession, adds to aggregate demand and stimulates through the multiplier. Cutting government spending then would be destructive to--would reduce aggregate demand and would reduce income--GDP.
And at an even slightly more basic level, you could argue--you don't, but you could argue that it doesn't matter whether you have tax increases or government spending cuts. They both reduce aggregate demand and therefore in a recession they are not productive; they are harmful. And yet you find that they have very different effects.
So, I want to talk about two things. We are going to start with the first. The first is going to be: Why might that be true? And the second is: How might one, how have you and your co-authors tried to actually measure that in a world where things are changing at the same time--other policies as you mentioned, reforms as well as certainly monetary policy which is one, I think, the main argument that some people make about trying to make conclusive statements about fiscal policy.