Austerity

Can cutting government spending actually grow an economy? The surprising data behind austerity may challenge everything you think you know.

1. What is Austerity, and Why Does It Matter?

Austerity refers to government policies intended to reduce budget deficits by either cutting spending, raising taxes, or both. While this approach is often unpopular, it seeks to address the fundamental challenge of stabilizing a nation’s debt. Think of a government managing its finances like a seasonal worker saving in good times to tide over lean periods. Unfortunately, many governments don't save during booms, leaving them unprepared for financial crises like the global recession of 2008.

Austerity becomes particularly critical when external shocks, such as economic crashes or pandemics, expose high levels of national debt. Countries like Greece and Italy, which had accumulated excessive debt before 2008, suffered doubly during the downturn. This forced them into implementing strict austerity measures to try and bring their finances under control. But as seen with Greece, poorly executed austerity can backfire terribly.

When done “right,” however, austerity can stabilize an economy. Based on decades of data from 16 developed nations, researchers found that the method—spending cuts or tax hikes—dramatically influences its success. The effects on public perception and economic outcomes also vary widely depending on how policies are implemented.

Examples

• Greece faced financial collapse after the 2008 crash due to years of unchecked debt.
• Italy's debt accumulation also left it vulnerable during the Great Recession.
• Countries like Canada succeeded with well-implemented austerity in the 1990s.

2. Austerity Isn’t Always Political Suicide

Contrary to widespread belief, austerity doesn’t always destroy a government’s chances of reelection. While tax hikes or reduced spending are typically unpopular, they don’t automatically doom leaders if policies are communicated effectively or produce long-term economic benefits. Surprising as it may seem, a government can still win elections even after introducing austerity.

Elections are influenced by many factors apart from fiscal policy, such as public support for specific reforms or confidence in leadership. Historical data show that voters sometimes reward choices they perceive as tough but fair or necessary. Indeed, carefully timed fiscal discipline can even strengthen voter support for pragmatic governance.

Countries like Canada, Sweden, and Finland have re-elected pro-austerity administrations after well-executed budget reforms. These cases challenge the notion that austerity is always a "kiss of death" in politics. Instead, political outcomes rely heavily on how governments implement tough measures and manage public expectations.

Examples

• Canada re-elected its government in 1997 despite significant spending cuts.
• Sweden’s 1998 election affirmed its leadership after years of fiscal control.
• The UK’s 2015 Conservatives thrived politically post-austerity.

3. Keynesian Theories Overlooked Modern Economic Factors

Economist John Maynard Keynes argued that government spending cuts can deepen recessions, while tax hikes cause only mild economic contraction. Yet more recent research challenges this theory by considering psychological and behavioral aspects often ignored in older models. The announcement of austerity doesn’t just reflect changes in spending or taxes—it also alters people’s expectations and confidence.

When governments cut spending, people may anticipate lower taxes in the future, incentivizing immediate consumption. On the other hand, tax increases prompt people to save more, further slowing economic activity. Confidence matters too: cutting spending can signal fiscal stability to investors, while higher taxes tend to dampen investment.

These nuanced effects suggest that expectations and incentives play a larger role in economic outcomes than Keynes envisioned. By incorporating these insights, modern interpretations give a fuller picture of how austerity truly works.

Examples

• Reduced government programs often create hope of future lower taxes, spurring investment.
• High taxes discourage workforce participation, while spending cuts encourage job-seeking.
• Investor confidence rises with clear signs of controlled spending, but weakens with high taxes.

4. Understanding Austerity Through Narratives, Not Just Numbers

Analyzing austerity is complex, as economic impacts often unfold over years. Standard economic models may fail to capture the subtle relationships between policy changes and outcomes. That’s why narrative approaches—tracking how both announcements and actual implementation influence economies—have proven effective.

The authors compiled data from countries that experienced fiscal consolidation between 1981 and 2014. By classifying cases as “expenditure-based” or “tax-based” austerity, they clarified the long-term effects of each type. This method helps disentangle austerity's direct impacts from external factors like global growth or structural reforms.

Their approach emphasizes that people often react emotionally and behaviorally to announced policies. That’s why narratives, which account for timing and public perception, shine a light on the broader economic and psychological aftermath of austerity programs.

Examples

• Policies from Canada, Sweden, and Australia show how narrative-based analysis clarifies long-term outcomes.
• Announcements of austerity measures themselves shift public behavior far before implementation.
• Countries with mixed austerity programs often reveal complex patterns, better understood through narrative contexts.

5. Expenditure-Based Austerity Offers a Path to Growth

Cutting government spending can yield better economic results than raising taxes. Sometimes, spending-focused austerity even leads to growth, a phenomenon the authors term “expansionary austerity.” By instilling investor confidence and addressing public expectations effectively, expenditure-based cuts can stimulate overall demand, offsetting the initial slowdown they might cause.

Illustrating this, Canada in the 1990s managed to lower its debt-to-GDP ratio significantly while its economy grew steadily. Austria in the 1980s experienced a similar turnaround by focusing on expenditure-based policies despite initial challenges. These examples defy older theories suggesting austerity universally shrinks economies.

Although conditions must align for expansionary austerity to occur, overall results for expenditure-based programs are consistently better than tax-focused alternatives, making them a more favorable policy choice under the right circumstances.

Examples

• Austria grew its GDP per capita significantly after early spending cuts in the 1980s.
• Canada reduced its massive debt-to-GDP ratio in the 1990s without halting growth.
• Most expenditure-based cases in the dataset showed only mild GDP contractions, if any.

6. Tax-Based Austerity Deepens Recessions

Tax hikes designed to balance budgets typically harm the economy more than they help. Raising taxes not only dampens consumer spending but also discourages investment and workforce participation. These factors combine to push economies into longer and deeper recessions compared to spending cuts.

Historical examples showcase this pattern. In the 1980s, Ireland’s tax-heavy austerity stalled its economy without achieving fiscal goals. Similarly, Portugal found its economy shrinking for two consecutive years during a tax-based austerity program in the 1980s. The consistent evidence across countries shows that tax policies disproportionately hurt economic output.

Tax-focused measures also obstruct investor confidence. Higher taxes reduce both disposable income and wealth expectations, making recovery through private-sector investment harder.

Examples

• Ireland suffered rising debt-to-GDP ratios with its 1980s tax-focused austerity program.
• Portugal’s GDP fell even as European economies grew during its 1983 tax austerity.
• Data confirms that tax-based austerity causes prolonged recessions in nearly all cases.

7. The Role of Austerity After the 2008 Financial Crisis

Austerity took center stage after the 2008 crash, with countries trying to stabilize their economies through fiscal consolidation. Results varied widely depending on each country’s initial debt level, austerity approach, and external pressures.

The UK cut spending in the early 2010s and saw a remarkable turnaround in GDP growth. Conversely, Greece’s massive spending cuts—forced by international agreements—pushed its economy further into collapse. The crisis starkly highlights the importance of tailoring austerity policies to a country’s specific situation and long-term needs.

The contrasting cases emphasize that while austerity often seems unavoidable, its success depends on both execution and initial conditions.

Examples

• The UK grew GDP 1.6% annually post-2010 austerity measures focused on spending cuts.
• Greece’s debt soared to 180% of GDP despite severe austerity enforced post-crash.
• Different economic contexts explain why the same approach leads to varied outcomes.

8. Timing May Be Less Important Than Strategy

Governments often debate when austerity should begin—during an economic downturn or recovery. The authors argue that timing matters less than the structure of measures. Whether the government leans toward tax increases or spending cuts has far greater implications for success.

If austerity relies heavily on taxes, starting during a downturn could deepen the slump. Spending cuts are more likely to succeed even in weak conditions due to their less severe immediate impact. Ultimately, focusing on expenditure-based reforms is critical regardless of the starting point.

Examples

• Canada’s success emerged despite starting austerity when debt levels were already high.
• Greece’s failure shows why overly aggressive tax-and-cut measures don’t guarantee stability.
• Historical evidence supports strategic measures over arbitrary timing decisions.

9. Challenges in Implementing Spending Cuts

Despite clear advantages, governments often struggle to prioritize spending cuts over tax hikes. Political resistance and competing priorities make it harder to reduce budgets. Tax changes, in comparison, are simpler to execute but come with greater economic risks.

Budget cuts can also trigger debates over the value of specific programs. Politicians and bureaucracies fiercely defend their allocations, citing potential costs to sectors like education or health. Even when austerity measures are urgently needed, the political battle often favors short-term tax measures over difficult reforms.

Examples

• Policymakers often compromise by implementing minor cuts alongside increased taxes.
• In countries like Sweden and Finland, leaders required extensive negotiations for larger spending adjustments.
• Greece’s crisis demonstrated how external pressures can override practical planning.

Takeaways

1. When planning austerity measures, prioritize spending cuts over tax increases to better stabilize the economy.
2. Consider the psychological impact of announcements and aim to manage public expectations positively.
3. Tailor austerity programs to national circumstances and build wide political consensus for effective implementation.