Does Austerity Work?

Recently The Economic Focus column in The Economist had an article that discussed how successful austerity is in generating growth in an economy. Barack Obama said “We have to cut spending we can’t afford so to put the economy on sounder footing and to give our businesses the confidence they need to grow and create jobs”. The UK and the European Central Bank (ECB) are also followers of Obama and argue that cuts to government deficits add to the GDP of an economy. The ECB argues that a fiscal contraction (reduced government spending and increased taxation) may turn out to be expansionary if expectations of lower future taxes and higher lifetime earnings become particularly strong. However, recent research states that this hardly ever happens. A study of 173 fiscal-policy changes in developed economies between 1978 and 2009 showed that cutting a budget deficit by 1% of GDP on average:

* reduces real output by about 2/3 of 1%
* increase unemployment 1/3 of 1%

There have been some cases where economies have grown with the implementation of austerity measures.

Denmark
In Denmark between 1983-86 budget cuts actually led to a rise in domestic demand and consequently GDP. However its economy was already growing at 4% when austerity commenced. Furthermore, interest rates already at 23% came down as the fiscal environment improved. House prices rose by 60% increasing wealth and confidence.

Ireland
Between 1987-89 improved budgetary conditions led to greater growth in the Irish economy. Again, like Denmark, Ireland had high rates of interest (13%) and with a more prudent approach rates dropped as did the Irish currency (the Punt) at the time. This led to an increase in exports by 10% from 1987-90 accounting for most of the growth of the Irish Tiger.

Italy
From 1991 – 1998 budget surpluses were used to pay off debt. But it was Italy’s exit from the Exchange Rate Mechanism (ERM) – see previous post on ERM – that led to a 40% decrease in value of the Lira against the D-mark. Again a weaker exchange rate led to more competitive exports and the Italian current-account went into a surplus and GDP increased.

The success of austerity programmes are characterised by initially high interest rates and weaker currencies which have led to export growth. However, America will struggle to replicate these as:

1 Their interest rates are near 0% already
2 Export volumes will be hampered by weak demand because of debt reduction in other developed nations.
3 Exports only account for a small proportion of their GDP
4 With China holding so much debt in US$ they will not want to see a dollar depreciation.

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