Keynes argued that recessions can arise from insufficient effective demand for goods and services in an economy that results in unused labour unemployment and capital excess capacity so that the actual output of the economy is less than its potential.
By raising public spending, overall demand can increase to use excess labour and capital and increase economic growth. Thus, where demand is temporarily insufficient to employ all the available labour and capital, more public spending is beneficial to the economy.
The message of Keynes, the antithesis of austerity, has been misconstrued by some to suggest that increased public spending is always good. It is as an extreme view as those who believe that reduced public spending is always good. Neither are true. The benefit of public spending depends on what the government choses to spend its money, the overall level of public debt and what point along the business cycle boom or bust is this public spending taking place.
Unlike some of his followers, Keynes most certainly did not argue for increased public spending at every point along the business cycle. This is consistent with the view that over a business cycle government budgets should balance.
In other words, governments should be generating surpluses revenues exceed spending when the economy is booming and, only in recession, should governments incur deficits spending exceeds revenues. The standard orthodoxy of economic policy-making, based on Keynes, is to increase public spending during economic downturns or recessions.
Indeed, the response of G20 countries to the Global Financial Crisis aka the Great Recession in was to increase public spending in a co-ordinated way with the expressed purpose that this spending would raise economic growth and avoid a global economic meltdown. This fiscal expansion worked, as it has many times before in national economies when countries have been in a demand-deficient recession. The challenge for those who want to increase public spending when there is insufficient effective demand is to also balance the government budget over the business cycle.
In a democracy it is, typically, much harder to lower public spending than it is to increase public spending. His research method — a long poem about his theory — is hardly convincing to modern ears.
Sometimes, just maybe, the austerity programme boosts confidence in such a way as to ignite a recovery. We have to examine the issue with some care, understanding that the issue that Mandeville raised is really a statistical one: the outcome of government deficit reduction is never entirely predictable, so we can ask only how likely such a plan is to succeed in restoring economic prosperity. And the biggest problem here is accounting for possible reverse causality. For example, if evidence of future economic strength makes a government worry about economic overheating and inflation, it might try to cool domestic demand by raising taxes and lowering government spending.
If the government is only partly successful in preventing economic overheating, it might nonetheless appear to casual observers that austerity actually strengthened the economy. Likewise, the government's deficit might fall not because of austerity, but because the stock market's anticipation of economic growth fuels higher revenues from capital-gains tax.
Once again, we would see what might appear, from looking at the government deficit, to be an austerity-to-prosperity scenario. Jaime Guajardo, Daniel Leigh, and Andrea Pescatori of the International Monetary Fund recently studied austerity plans implemented by governments in 17 countries in the last 30 years.
But their approach differed from that of previous researchers. They focused on the government's intent, and looked at what officials actually said, not just at the pattern of public debt. They read budget speeches, reviewed stability programmes, and even watched news interviews with government figures.
They identified as austerity plans only those cases in which governments imposed tax hikes or spending cuts because they viewed it as a prudent policy with potential long-term benefits, not because they were responding to the short-term economic outlook and sought to reduce the risk of overheating. Their analysis found a clear tendency for austerity programmes to reduce consumption expenditure and weaken the economy.
That conclusion, if valid, stands as a stern warning to policymakers today. The financial crisis hit these countries hard. As a result, they needed bailouts to keep from defaulting on their sovereign debt.
He also cut subsidies to regional governments, family tax benefits, and the pensions for the wealthy. They voted him out of office. His replacement, Mario Monti, raised taxes on the wealthy, raised eligibility ages for pensions, and went after tax evaders. It reduced welfare and child benefits and closed police stations. It cut military and infrastructure spending.
It increased privatization. Spain - Spain raised taxes on the wealthy. United Kingdom - The U. It cut the income tax allowance for pensioners and reduced child benefits.
France - The government closed tax loopholes. It withdrew economic stimulus measures. It increased taxes on corporations and the wealthy. Germany - The German government cut subsidies to parents. It eliminated 10, government jobs and raised taxes on nuclear power. United States - Although it was never called by the name "austerity measures," proposals to reduce the U. A stalemate over these austerity measures led to the U. Spending cuts and tax increases became an issue.
Congress refused to approve the Fiscal Year budget in April , almost shutting down the government. It averted disaster by agreeing on mild spending cuts. In July, Congress threatened to default on the U.
It again averted disaster when the two parties agreed to a bipartisan commission to study the matter. Congress also imposed a budget sequestration if nothing was resolved. Congress resolved it with a last-minute agreement. Despite their intentions, austerity measures worsen debt and slow economic growth. In , the IMF released a report that stated the eurozone's austerity measures may have slowed economic growth and worsened the debt crisis.
For example, Italy's budget-cutting calmed worried investors, who then accepted a lower return for their risk.
Italy's bond yields dropped. The country found it easier to roll over short-term debt. The timing of austerity measures is everything. Lowering government spending and laying off workers will reduce economic growth and increase unemployment. The government itself is an important component of GDP. Likewise, raising corporate taxes when businesses are struggling will only cause more layoffs.
Raising income taxes will take money out of consumers' pockets, giving them less to spend. The best time for austerity measures is when the economy is in the expansion phase of the business cycle. The World Bank. International Monetary Fund. Organization for Economic Cooperation and Development. Federal Reserve Bank of St. OECD Publishing, James Jackson. Diane Publishing,
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