Is austerity the answer to Europe's crisis?

Authorde Rugy, Veronique
PositionEssay

Austerity is a term used to describe debt-reduction policies, but it can mean radically different things. For some people, austerity means adopting a debt-reduction package dominated by tax increases. For others, it means adopting a package made mainly of spending restraint--including reforms of social programs. The lack of a distinction between the two meanings of the word--and hence, the distinction between two different debt-reduction policies--is unfortunate and could also explain the confusion over what is happening in Europe.

In this debate there are two important questions to keep in mind. The first question asks, Which of the two types of austerity measures successfully reduces the debt-to-GDP ratio? The second asks, What is the impact of austerity measures on economic growth?

Which of the Two Types of Austerity Measures Successfully Reduces Debt to GDP?

The United States is not the first nation to struggle with a worrisome debt-to-GDP ratio. Fortunately, the academic world has already produced great insights into what can be done to help the problem without hurting the economy. Take Harvard University economists Alberto Alesina and Silvia Ardagna. In an October 2009 working paper published by the National Bureau of Economic Research, the duo look at 107 efforts to reduce debt in 21 OECD nations between 1970 and 9.007. Several countries were successful, among them Austria in 2005, Finland in 2005, and Sweden from 1997 to 9,004. Spending cuts, the scholars found, are more effective than tax increases in reducing the ratio of debt to GDP. With successful fiscal adjustments, spending as a share of GDP fell by an average of 2 percentage points while revenue fell by half a percentage point. Unsuccessful fiscal-adjustment packages involved smaller spending reductions (only about eight-tenths of a percentage point, on average) and large revenue increases.

Following and building on the work of Alesina and Ardagna (2009), American Enterprise Institute economists Andrew Biggs, Kevin Hassett, and Matthew Jensen published a working paper in December 2010 covering more than 100 instances in which countries took steps to address their budget gaps. They identify successful consolidations as those in which the ratio of debt to potential GDP three years following the first yea" of the consolidation declined by at least 4.5 percentage points. Their conclusion: "Countries that addressed their budget shortfalls through reduced spending burdens were far more likely to reduce their debt than countries whose budget-balancing strategies depended upon higher taxes." What's more, "the typical unsuccessful fiscal consolidation consisted of 53 percent tax increases and 47 percent spending cuts. By contrast, the typical successful fiscal consolidation consisted of 85 percent spending cuts."

These results are extremely mainstream. My colleague at the Mercatus Center Matt Mitchell has done a review of the academic literature on this issue and he finds of the 22 papers published that looked at this question all of them find that the most promising way to shrink file debt is to restrain spending so it shrinks relative to economic output and not to increase taxes (Mitchell 2011).

But...

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