Can austerity work?

Abstract

Economic policies in several major countries have shifted from fiscal stimulus to austerity in the last few years. They seek to reduce fiscal deficits and reverse the increasing trend of public debt mainly through immediate spending cuts. The fact that fiscal austerity is applied simultaneously in these countries adds to its negative impact on economic recovery. Austerity policies are based on a wrong diagnosis of the nature and depth of the crisis, and also on erroneous views of economic mechanisms. This is a financial crisis due to private over-indebtedness and financial deregulation,not a crisiscaused byfiscal profligacy: austerity focusesona symptom of the crisis, not on its causes. With high unemployment and the ongoing de-leveraging process, private demand tends to remain subdued for a prolonged period and will not be stimulated by monetary expansion alone. If in addition governments tighten fiscal policies, demand and growth will be further compressed, fiscal revenues will decline, expected fiscal consolidation will remain elusive and so will the recovery of investors’ confidence, which many see as the key to restoring growth. Only a recovery of growth, with nominal GDP expanding at rates higher than interest rates in the medium and long run will abate debtto-GDP ratios. That growth can result from coordinated supportive policies, which may include changes in the level and composition of public income and expenditure and a better distribution of income and credit, which would expand fiscal multipliers and the purchasing power of low and medium income groups with a high propensity to consume.