Debating austerity

Austerity: When it works and when it doesn’t 

Alberto Alesina, Carlo Favero, Francesco Giavazzi 

Princeton University Press; Pages 276

Under the basic Keynesian model, the impact of austerity measures on the economy is quite straightforward. Cuts in government spending reduces aggregate demand, which leads to a fall in output, lowering gross domestic product and private income. This creates a multiplier effect as a fall in private consumption translates to a further fall in output.

The greater the propensity to consume out of current income, in other words, the lower the propensity to save, and the greater is the multiplier effect. This fall in aggregate demand also deters investments. 

On the other hand, an increase in taxes negatively impacts output, though to a lesser degree. Higher taxes reduce personal disposable income thereby translating to lower consumption. But as consumers spend only a fraction of their disposable income, they also tend to save, so higher taxes have a smaller impact on output.  Thus, under this model, austerity implemented through spending cuts is more harmful than that implemented through raising taxes.

This basic Keynesian framework continues to dominate popular discourse. However, economists Alberto Alesina, Carlo Favero and Francesco Giavazzi differ from their approach. In a new book titled Austerity – When it Works and When it Doesn’t  the economists, who have long researched the effects of austerity, argue that the typical anti-austerity argument that tax increases and expenditure cuts “cause  long lasting recessions,” does not present the complete picture for many reasons. 

For one, “the effects of fiscal policy are not limited to the demand side of the economy.” Rather, changes in tax structure and government spending also creates incentives that influence the supply side. 

Second, “economic decisions of consumers, investors, workers and savers depend not just on the present but also on expectations of future.” This is important “as decisions regarding taxes and spending made today affect the future.” 

At the crux of the book is the notion that when governments are facing an unsustainable debt position, it is much better to rein back deficits through spending cuts rather than tax increases. Marshalling decades of data, the authors argue that an “increase in labour taxes tends to reduce labour supply while simultaneously raising labour costs and thus prices”. Further, higher taxes, also reduce disposable income thereby reducing aggregate demand. 

On the other hand, even though spending cuts reduce aggregate demand, “if they are perceived as permanent, they will lead to expectations of lower taxes in the future.”  This, they argue, has ramifications for consumer spending today.  

According to economists Milton Friedman and Franco Modigliani, consumption decisions are based not only on current incomes but also on long-term incomes. If consumers expect lower taxes in the future, then “private consumption may react immediately to the announcement of a permanent cut in government spending,” the authors argue. 

Then there’s also the investment effect. The authors contend that if investors expect future taxes to go up to pay for government spending they are less likely to invest today for two reasons. First, they are likely to face higher taxes in the future. And second, higher taxes levied on consumers will also reduce demand in the future. 

On the contrary, a cut in government spending signals a reduction in future taxes, which may stimulate investment today. 

Thus, in their view, the negative effects of austerity are outweighed by the impact of austerity in boosting household and investor confidence —which in turn will get them to spend. They estimate that although tax-based austerity drives lead to “deep and prolonged recession” that lasts many years, the recessionary impact of expenditure-based austerity dissipates “within two years after a plan is introduced.”  

At the crux of their argument is the belief that expectations and confidence matter. This is a tall order. Also, much of the debate lies in estimating the magnitude of these fiscal multipliers. This is where analyses differs. 

While economists will continue to debate on the merits and demerits of expansionary or contractionary fiscal policies, the fundamental question is whether austerity is a politically saleable proposition. Is austerity a bad word? Will voters reward governments who boost spending or those who pivot to parsimony? 

The authors note that “in academia and political circles the idea is that voters always punish incumbents who raise taxes or cut spending to reduce deficits.”

This argument stems from the line of thinking that voters, guided by short-term imperatives, are more likely to vote for governments who increase spending, without an understanding of the future costs that such higher current spending entails. However, the authors disagree. According to their estimates, “the recent historical evidence on electoral effects of austerity, the results are much less clear cut than the conventional wisdom would suggest.”