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Fiscal Fallacies: 8 Myths about the 'Age of Austerity'

Myth #2: Deep cutbacks, especially to expensive social entitlement programs, are the only way to fix the deficit, calm the markets and thereby revitalize the economy

Starting in 2010, governments across the world sharply cutback in public spending fearing that climbing deficits would startle bond markets. Deficit hawks re-gained the edge, arguing for the need to “cut the way to growth.” According to this popular myth, high budget deficits—regardless of their origins—suggest to investors and creditors that governments aren’t able to repay their outstanding bonds obligations. This leads to escalating costs to finance the debt (interest rates), which purportedly suppresses economic growth and employment generation. The best way to restore confidence amongst anxious investors and creditors, according to this position, is to “calm the markets” by decisively cutting public spending (especially on social “entitlement” programs which create debt burdens for generations) to urgently pay down the deficit, regain the trust of bond markets, lower interest rates and thereby increase economic growth.  The “cut to grow” fever has caught fire, with many low- and middle-income countries joining the headline countries in Europe and the US to cut public expenditure, at times excessively, on the assumption that austerity will drive growth. The IMF, despite warnings against excessive austerity from its new managing director Christine Lagarde and from its own recent reports, has not strayed far from this line, advising many countries to cut budgets in dire economic circumstances in 2010-11, according to UN reports.

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In practice, however, evidence shows that when the economy is sputtering these types of “cut to grow” approaches to fiscal policy are dangerously self-defeating in that they often worsen the deficit level problem they attempt to solve. Governments from the UK to Ireland to Portugal, Spain and Greece have tried to calm bond and financial markets by slashing their budgets in draconian fashion. Yet, the interest rates on their bonds have in many cases increased. In each of these cases, growth prospects are actually worsening as a result, as lower levels of growth and higher unemployment coming as a result of public cutbacks decreases tax generation, making the fiscal crises even worse. In both Greece and Ireland—poster countries for the “cut to grow” school—austerity policies demanded in their agreements with the Troika - European Union (EU), European Central Bank (ECB) and IMF - arguably shrunk the national economies, compelling governments to repeatedly adjust downward their growth forecasts. As the economies slow and revenue becomes scantier, budget targets are ever harder to meet, and interest rates on bonds tend to rise, soliciting even deeper budget cuts. Greece’s debt to GDP ratio, for example, was 130 per cent in late 2009. In late 2011, after two years of severe austerity measures, it had risen to over 160 per cent. After years of fiscal entrenchment, growth has continued to suffer in Ireland. Spain is the latest casualty of the austerity trap, as its 2012 public budget slashing is set to reduce GDP in the country by 2.6 per cent according to the government’s own estimates. Spain’s borrowing costs, meanwhile, continue to soar. Even the OECD—not exactly a bastion of heterodox economics—stressed that “eurozone policy makers have to look for growth policies to offset fiscal austerity.” Given the interdependence of the global economy, UNCTAD is openly concerned that EU austerity policies may threaten a global recession

Austerity as a driving factor in economic downturns and fiscal deficit is not merely circumstantial to Europe in 2012. “Austerity has never worked,” in the words of Cambridge economist Ha-Joon Chang. Historical evidence, including from the IMF, suggests cutting budgets during economic recessions has a tendency to actually increase deficits while deepening and prolonging the recession, worsening unemployment levels and extending the time economies take to fully recover in economic terms. Public budget-cutting in the midst of an economic recession is tantamount to digging oneself deeper and deeper into the same hole, a never-ending austerity trap governments across the world, none more than in certain EU governments, seem intent on verifying. As conservative British economist Lionel Robbins once admitted in the 1930s, these types of austerity policies are “as unsuitable as denying blankets and stimulants to a drunk who has fallen into an icy pond on the ground that his original trouble was overheating.”

Even for deficit hawks, history shows that the best way to pay down deficits is by getting the economy moving again by creating more and better-paying jobs. In times of recession, this can best be done through economic stimulus policies which invest in human and productive assets which can battle inequalities while driving growth. These can include monetary policies to lower interest rates, but also fiscal policies which increase effective public spending in downturns (also called counter-cyclical policies). Although it may seem counterintuitive at first to actually increase deficit spending during downturns, higher public spending in the midst of a recession can make up for the drop in private sector spending and stimulate the economy, especially if invested smartly in economic and social rights programs which simultaneously build long-lasting social and economic assets while also boosting the spending capacity of low- and middle-households which have a higher propensity to spend than richer households. The resulting increase in tax revenues from growth can then be used to pay down the deficits over the medium term.

In late 2011 many mainstream economists began to speak out against budget austerity and  for further economic stimulus, such as Douglas Elmendorf, the director of the US Congressional Budget Office, Cornell University economist Robert Frank, Indian economist Deepak Nayyar, UC Berkeley economist Brad DeLong, Harvard University economist and former director of the White House National Economic Council, Lawrence Summers, and economist Nouriel Roubini. As economic conditions deteriorated into 2012 across the eurozone, India and China, a deeper political shift against budget austerity has gained momentum, as seen in elections in France and Greece. By the June 2012 G20 summit, the US and other members had begun to formally call for less austerity, increasingly putting Germany on the defensive as it continues to call for austerity as the solution to the crisis.

Human rights responses

Contrary to the “cut to grow” myth, countries have often paid down their high deficits only after economic growth rates, decent employment and tax collections resume. In addition to traditional economic stimulus policies, governments can also invest in social protection and unemployment insurance to stimulate growth. By putting resources into people’s pockets, especially those more likely to affect economic demand through spending, social protection programs can have a stimulating effect on the economy, particularly in times of recession. Low-income households already facing deprivations in income and opportunity are most likely to demand their basic needs are met, and can be powerful agents to stimulate their own economies from the ground-up by creating the sustainable conditions for the economy and government revenues to recover, at which point budget deficits can be addressed. Similarly, evidence shows that improving early-childhood nutrition can boost GDP by two to three percent in poor countries. UNICEF meanwhile has found that increased learning achievements in children can increase a country’s long-term overall growth rate, and a girl’s future wages by between 10 and 20 percent with every extra year of primary school — with long-lasting waves of benefit to her broader family, community and economy.

In sharp contrast to the “cut to grow” myth which claims budget austerity is the only solution, evidence suggests that investing in ordinary people through social and economic programs, particularly when prioritizing social protection floors - affordable to even the poorest countries - can support the enjoyment of economic and social rights, while simultaneously adding the badly-needed fuel to help rouse and balance our global economy on the brink of recession.

Photograph of International Monetary Fund Managing Director Christine Lagarde courtesy of IMF. This briefing can be accessed in pdf format here.