Austerity is not a dirty word
A review of “Austerity: When it Works and When it Doesn’t”
Cover of “Austerity: When It Works and When It Doesn’t” by Alberto Alesina, Carlo Favero, and Francesco Giavazzi
Alesina, A., Favero, C., & Giavazzi, F. (2019). Austerity: When It Works and When It Doesn’t. Princeton University Press. 276 pages.
Overview
The purpose of fiscal austerity policies is to decrease government deficits and stabilize debt through spending cuts, tax hikes, or both. It’s a controversial policy solution, weighed down with too much political baggage from both the left and right. Thankfully there’s now a book that cuts through the political rhetoric, helping societies interested in improving their financial health while making sense of austerity’s costs and benefits.
In “Austerity: When It Works and When It Doesn’t,” authors Alberto Alesina, Carlo Favero, and Francesco Giavazzi focus on three things: one, the costs of austerity as lost output; two, the types of austerity that can achieve its goals (decrease deficits and debt stabilization); and three, the electoral effects for governments pursuing those policies.
The authors are more than qualified to analyze and comment on this controversial fiscal policy. Alesina is the Nathaniel Ropes Professor of Political Economy at Harvard University, Favero is the Deutsche Bank Chair in Quantitative Finance and Asset Pricing at Bocconi University in Italy, and Giavazzi is a professor of economics at Bocconi University, too.
The book is valuable for several reasons. For one, the authors’ quantitative approach to analyzing austerity policies is expansive. Their data encompasses 200 multi-year austerity plans of sixteen OECD countries from the late 1970s to 2014. Their methodology focuses on multi-year fiscal plans and their effects on the economy rather than a period-by-period analysis, including analyses on different tax and expenditure plans (p. 9-10). To top things off, they ask the contentious question as to whether fiscal austerity plans are bad for electoral governments (p. 10); short answer, they don’t look all that bad.
Lessons learned
Early in the book, the authors present and answer crucial questions and thoroughly lay out the theoretical foundations of fiscal austerity.
For example, they describe two types of austerity. The first type involves direct and indirect tax increases. Increased taxation is recessionary in the short to medium run (three to four years) in OECD countries with already high tax rates. Additionally, they cause an increase in the debt-to-GDP ratio (p. 3). The second type of austerity involves spending cuts (p. 4), the better option for fiscal consolidation because the recessionary effects wear off within approximately two years (p. 12).
However, it’s a bit more complicated. Three types of expenditures can be cut: current spending; capital spending, whereby a decrease may affect long-term productivity; and transfers to citizens, which result in less disposable income for the poor, and therefore less aggregate demand, but encourages greater labour force participation (p. 25-26).
But when should governments implement austerity plans? The authors argue that austerity should be implemented when governments’ “potential costs are lowest” (p. 6); to be clear, this does not mean when not in a recession.
The arguments, supporting evidence, and data are clearly presented throughout the book. Though it’s from an academic press, most of the book’s chapters are easy to follow for laypeople. Still, “Austerity” is a vital companion for readers with strong backgrounds in statistics and econometrics. Anyone looking for case studies rich in data for the developed world will benefit from this book.
Here are some valuable lessons I gleaned when reading “Austerity.”
Expenditure-based austerity plans are better than tax-based austerity plans. In chapter seven, “The Effects of Austerity,” the authors demonstrate why reducing government expenditures is better than raising taxes as an austerity measure because the recessionary effects exhaust after two years (p. 97), which ultimately reduces debt (p. 111-112). Specifically, GDP, consumption, investment, net exports, and consumer/business confidence perform better when governments cut expenditures than raising taxes. Though GDP reduces marginally, investors respond positively since they know they won’t face higher taxation. At the same time, consumers remain relatively well off so long as their ability to borrow improves or their income improves (p. 100). Of course, nothing is ever perfect. One of the book’s strengths is the authors’ fair assessment and nuanced thinking regarding this contentious topic. They admit that the decrease in transfers to individuals results in less disposable income for the neediest. However, the effects of expenditure reduction also show an increase in labour supply since individuals must further participate in the labour market (p. 102). It’s upsetting for many to read of this, but policy-makers must consider the facts as objectively as possible and let the evidence guide their decisions.
Campaigning on austerity measures does not necessarily mean political suicide. Contrary to what many believe, political parties can win elections on austerity platforms. The authors share examples of governments that were re-elected because of their austerity plans, such as Canada’s Liberals in 1997, Finland’s Social Democrats in 1999, and Sweden’s social Democrats in 1998 (p. 185). To be clear, the authors are not suggesting that austerity platforms will win elections. The current narrative that austerity is disastrous, however, is indeed misleading. Strangely, they also found in their data that right-of-centre governments were less likely to implement expenditure-based fiscal adjustment plans (p. 181) – who would have guessed? These insights are important since they illustrate how voters care about economic pragmatism and rational leaders when the conditions are right. They are not solely concerned with the personality traits of those vying for political power. Of course, it can be hard to tease apart the significance and contributing factors associated with these highly qualitative variables, but, overall, the authors show us austerity platforms are not the kiss of death.
Canada’s expansionary austerity policy in the 1990s was a success for the most part. The federal government adopted monetary and structural reforms, including spending cuts and structural reforms, for increased productivity. According to the authors, the spending cuts made up roughly two-thirds of the adjustment, entailing decreased business subsidies, public employment, and federal-provincial transfer payments. On the other hand, the structural reforms involved deregulation, privatization, increased R&D spending, and small business plans. It looks like Canadian federal politicians at the time followed first-year economic theories. However, it’s important to note that there were slight increases in direct and indirect taxes (the authors list several examples) (p. 38).
Overall, the effects of Canadian fiscal consolidation in the 1990s led to a decrease in the Consumer Price Index (suggesting that life became more affordable), an increase in consumption (indicating higher consumer confidence), a significant reduction of the total deficit as a percentage of GDP by 1999, and a decrease in the cost of debt payments due to cheaper finance and better interest rates. The output per capita growth rate was also positive from 1993 to 1997. These details are worth emphasizing since many believe that perpetual stimulus is necessary to induce demand and higher economic growth, even when the opposite approach (i.e. spending cuts) is also valid. The authors explore several other effects of these two approaches, all beautifully summarized in Table 3.6 on page 40 (I don’t have permission to republish the graph).
Any Canadian policy person interested in further teasing apart the data points should review the numbers themselves. Being a Canadian, I had to share this key takeaway from the book. The plan is still lauded as one of the best strategies among pro-austerity pundits today, considering its positive effects. But there’s one crucial thing to understand: all major political parties in Canada supported the austerity plan in 1993 when the Liberals were in power under Prime Minister Jean Chrétien. If anything, the case study shows us that significant changes require broad public and political support to be viable, no matter who’s in charge.
Other important topics explored in this book include:
In-depth case studies, by country and austerity plan, and their results, including Austria, Belgium, Ireland, and Portugal in the 1980s, and Spain in the 1990s. These case studies are the book’s most valuable contributions to fiscal policy.
The differences between coalition governments and majoritarian ones regarding austerity plans (p. 181).
The political reluctance of adopting austerity plans (p. 187).
Justifications for tax-based austerity plans when expenditure-based plans are more effective (p. 188 to 192). The authors explore four significant reasons.
Overall impression
I enjoyed reading “Austerity.” It challenged many of my preconceived notions about this controversial subject. I like to naively believe that citizens will respond positively to higher taxes knowing their governments will be better equipped for more comprehensive social welfare policies and capital investments. But the reality is that austerity via expenditure cuts may be necessary to decrease the deficits and stabilize existing debt, as the past few decades have shown. Moreover, according to their data, it appears people will find a way to get to work when direct financial transfers are reduced. Sometimes tough medicine is the correct approach.
If you are staunchly opposed to public expenditure cuts, you need to read this book. We must remain committed to challenging our beliefs and opinions, constantly seeking different perspectives and accepting other arguments when quantifiable facts support them. Admittedly, it isn’t easy. But thanks to the work of Alesina, Favero, and Giavazzi, we can think of fiscal policies differently from here on.