Economics in Context Update April 2015 Designed for use with the Global Development And Environment Institute’s In Context textbooks

The Impact of Austerity Policies in Europe

As discussed in the text, in re- concluded that the benefits of Blanchard’s paper notes that fiscal sponse to the global financial lower government spending, and multipliers change over time, and crisis several European countries thus reduced budget deficits, out- may tend to be higher during were pressured into pursuing weighed the costs of a reduction recessions. If this is true, that austerity policies. Through gov- in GDP. In Greece, for example, would imply that expansionary ernment spending cuts and/or tax the IMF predicted that the pro- policies, rather than austerity, increases, austerity policies seek posed austerity policies would might be the more desirable poli- to reduce national debts. While reduce GDP by 5.5% cy prescription. If the multiplier a reduction in national debt from during a recession is, say, 1.5, that unsustainable levels can restore By 2013 the Greek economy would indicate that a 1% increase market stability, such contraction- had contracted by 17%, and the in government spending will ary fiscal policies during a reces- negative impacts of austerity on lead to a 1.5% increase in GDP, sion may prolong and deepen the GDP in other European countries along with a concurrent increase downturn. were also higher than expected. A in tax revenues. Other economic January 2013 paper co-written by analysis by the IMF suggests that The International Monetary the chief economist of the IMF, austerity policies may be advisable Fund (IMF) was among the Oliver Blanchard, reassessed the when an economy is expanding, organizations promoting austerity IMF’s estimates of the fiscal mul- but are harmful both in the short- policies in Europe, on the basis of tiplier, concluding that the actual and long-run when an economy is economic analysis estimating the value was somewhere between in recession. impact of changes in government 0.9 and 1.7. Not only does this expenditures on real output. This imply that austerity reduces GDP Nobel Prize-winning economist analysis hinges on something more than expected, but it also Joseph Stiglitz wrote in Septem- called the fiscal multiplier, which means that austerity policies are ber 2013: the IMF assumed was around less effective in reducing gov- The wave of economic austerity 0.5. This means that a 1% re- ernment debts. When austerity that has swept Europe in the duction in government spending significantly reduces GDP, that wake of the Great Recession will reduce real GDP by 0.5%. leads to lower overall tax revenues, is at risk of doing serious and Based on the situation in several thus offsetting the deficit-reduc- permanent damage to the European countries in the wake ing benefits of lower government continent’s long-cherished of the financial crisis, the IMF spending. social model. As economists,

Note: This update specifically relates toMacroeconomics in Context Chapters 15 and 16, and Principles of Economics in Context Chapters 30 and 31. For more information about the books, teaching materials, and research, see www.gdae.org including myself, have long Finally, in November 2014 the predicted, austerity has only IMF’s Independent Evaluation crippled Europe’s growth, with Office published a report evaluat- improvements in fiscal positions ing the IMF’s recommendations that are always disappointing. during the financial crisis. The Worse, it is contributing to in- report concludes that: equality that will make econom- the call for fiscal consolidation ic weakness longer-lived, and [austerity] proved to be prema- needlessly contributes to the ture, as the recovery turned out suffering of the jobless and the to be modest in most advanced poor for many years. (Oxfam, economies and short-lived in 2013, p. 2) many European countries. … The policy mix pursued However, not all economists agree by advanced economies had that austerity has failed, at least destabilizing spillover effects on not in all countries. Latvia pur- emerging markets, exacerbating sued rather severe austerity mea- volatility in capital flows and sures after the financial crisis, and exchange rates. Also, the IMF by 2012 it was the fastest-grow- did not sufficiently tailor its ing of the 27 European Union advice to countries based on economies, with a significant their individual circumstances reduction in its budget deficit. A and access to financing when 2014 paper by the IMF analyzed recommending either expansion 91 instances of austerity policies or consolidation. (IEO, 2014, and found that in most cases the p. Ch. 5, p. 26) policies were successful in reduc- ing budget deficits.

Sources: Higgins, Andrew. 2013. “Used to Hardship, Latvia Accepts Austerity, and Its Pain Eases,” New York Times, January 1, 2013 Matthews, Dylan. 2013. “Austerity May Help Growth during Good Times. But Man, Does it Hurt during Bad Times,” Washington Post, April 18, 2013 Elliot, Larry, Phillip Inman, and Helena Smith. 2013. “IMF Admits: We Failed to Realise the Damage Austerity Would Do to Greece,” The Guardian, June 5, 2013 Oxfam. 2013. “A Cautionary Tale: The True Cost of Austerity and Inequality in Europe,” September 2013 O’Brien, Dan. 2014. “’Austerity Works’ Says the IMF’s Latest Study,” Independent (Ireland), November 23, 2014 Independent Evaluation Office (IEO). 2014. “IMF Response to the Financial and Economic Crisis,” November 2014.