Austerity doesn’t boost economic growth, it hinders it

The most basic definition of austerity (the one adopted globally since the 2008 financial crisis) is fiscal consolidation or adjustment measures to lower public expenditure and tame growing sovereign debt burdens.

It was widely adopted by many countries around the world in the wake of the 2008 global financial crisis in order to avoid recession, balance the books, reduce budget deficits and achieve a surplus, reduce public debt, as well as trigger economic growth. It’s an integral part of the neoliberal economic doctrine which has largely become the orthodoxy worldwide since the 1970s.

How has economic austerity faired in the 11 years since the financial crisis? Undoubtedly, it has been a decade of recurring social unrest, with the Arab Spring uprisings, the Occupy movement in the US, anti-austerity protests across Europe, and the recent revolts in Chile, Ecuador (which were in reaction to an IMF deal), Lebanon, and Iraq, throwing questions into the debate.

On October 24, Alternative Policy Solutions, a public policy research project at the American University in Cairo, hosted a lecture at the Tahrir campus entitled “Assessing Austerity: Monitoring the Impacts of Economic Policy on People’s Lives.” Sergio Chaparro, an economic policy expert at the New York-based Center for Economic and Social Rights and former adviser to the Colombian National Congress, came to give the lecture and revealed several facts and approaches which may surprise those on the pro-austerity side of the debate.

Currently, 50% of the world’s population are being affected by austerity measures, a figure set to rise to 75% by the year 2021 according to Chaparro. Developing countries have been pursuing austerity measure even more aggressively than high-income countries, with current projections showing that North African countries are set to continue reducing public spending beyond 2020.

The human impact of such economic policies has been huge and Chaparro believes that the last decade was a lost opportunity to raise public expenditure on essential services to reduce the impact of the 2008 financial crisis.

However, what has been the effect economically? What will be the future impacts of austerity? Alternative insights and research (including some from the International Monetary Fund) may be surprising to those who advocate for a market and growth-based economic model, as well as those prioritising debt servicing and reduction.

According to Chaparro, austerity measures can ironically exacerbate the issues they’re intending to solve by slashing the economy’s ability to bounce back from a recession or downturn. Austerity measures accompanied by market liberalization policies cause large increases in inequality, which in turn have negative effects on growth and the overall health of an economy.

According to an IMF working paper from 2015, open markets have distributional effects which cause inequality to rise. In 2013, a working paper by the United Nation’s Department of Economic and Social Affairs studied the effects of fiscal consolidation in 17 countries that are members of the Organization for Economic Cooperation and Development (OECD) from 1978 to 2009. It found that such periods of austerity led to a “significant and long-lasting increase in inequality.”

A 2016 article in the IMF’s Finance and Development publication summarized much of the organization’s research which showed how much fiscal consolidation created greater levels of inequality and consequently, negatively impacted economic growth in a significant number of countries.

“Instead of delivering growth, some neoliberal policies have increased inequality, in turn jeopardizing durable expansion,” the report said. “Increased inequality in turn hurts the level and sustainability of growth. Even if growth is the sole or main purpose of the neoliberal agenda. Advocates of that agenda still need to pay attention to the distributional effects.”

Referring specifically to the neoliberal policy of market openness to foreign direct investment (FDI), the report revealed that since 1980, more than 50 emerging market economies experienced around 150 episodes of surges of capital inflows. Around 20% of the time, such episodes ended with the countries slipping into financial crises, with many of these crises accompanying significant declines in output, according to a research paper published in the American Economic Review in 2016 entitled “When Do Capital Inflow Surges End in Tears?”

Harvard economist, Dani Rodrik, said these crises are “hardly a sideshow or a minor blemish in international capital flows; they are the main story.”

Research conducted independently by IMF staff in 2014 revealed more vividly how inequality is an impediment to economic growth, and even suggested that some wealth redistribution policies that aim to increase levels of equality do, in fact, promote growth.

A summary of the research stated: “since both openness and austerity are associated with increasing income inequality, this distributional effect sets up an adverse feedback loop. The increase in inequality engendered by financial openness and austerity might itself undercut growth, the very thing that the neoliberal agenda is intent on boosting. There is now strong evidence that inequality can significantly lower both the level and the durability of growth.”

Apart from growth, recent research conducted by Professor Ioannis Bournakis, an associate professor in the Department of Economics at the American University in Cairo, revealed that austerity measures have often also negatively impacted productivity.

Speaking to Business Forward, Bournakis said: “Emerging literature…is now becoming increasingly more concerned about the effects of austerity on the supply side of the economy, which has been overlooked [in the] previous literature, because the previous literature was only considering [that] there might be some sort of contractionary effect in the economy in the short run in terms of employment, consumption, and aggregate investment, and the discussion was stopped there. Our paper and our studies basically contributing to that is that maybe this is only one side of the story.”

Public spending and investment cuts to essential sectors such as infrastructure, education, healthcare, and “other very functional aspects of the government…have serious negative effects on the productive capacity of the economy,” he continued. “If you really want to understand the effect of austerity on the economy, you should look at the effect of austerity on the supply side.”

The supply side of an economy refers to the productive capacity of an economy, which according to Bournakis includes crucial sectors such as infrastructure, telecommunication networks, research and development, and human capital.

“When the state stops investing in these factors, then even the private sector cannot function properly. What we all accept as a common knowledge is that basically, the government and the state provides the productive base for the economy […] If there are spending cuts in these sectors, then this will definitely affect the private sector too.”

Even the IMF study stated that “austerity policies not only generate substantial welfare costs due to supply-side channels, they also hurt demand—and thus worsen employment and unemployment […] In practice, episodes of fiscal consolidation have been followed, on average, by drops rather than by expansions in output.”

Bournakis disagrees with the notion that the private sector can adequately step in to replace functions and services that have traditionally been provided by the state.

“All these projects where the government’s spending are sectors that expand economies of scale and so on are high cost projects. It’s very difficult or very unusual for the private sector to undertake such projects.”

Chaparro also said that austerity can have indirect negative long-term impacts that stretch far into the future. Cuts to health, education, child care, infrastructure, and other public services have cumulative and compounding effects on the economy.

Cuts to health care can cause long-term health issues across the population which can become generational, creating for a less productive and smaller workforce in the future. Cuts to education will deprive future job markets of necessary skilled labor, an especially important factor in the context of the Fourth Industrial Revolution and high-tech economy.

“Increased public spending is actually more effective in times of economic crisis, as it tends to restore and maintain consumer confidence,” Chaparro added. In order for a country to improve rates of investor confidence, policies that improve consumer confidence have to be pursued.

Indeed, the IMF report even suggests a policy shift which recognises that fiscal consolidation and public spending aren’t necessarily mutually exclusive: “The evidence of the economic damage from inequality suggests that policymakers should be more open to redistribution than they are now. Of course, apart from redistribution, policies could be designed to mitigate some of the impacts in advance—for instance, through increased spending on education and training, which expands equality of opportunity (so-called predistribution policies). And fiscal consolidation strategies—when they are needed—could be designed to minimize the adverse impact on low-income groups.”

With a growing consensus among economists on the shortcomings of austerity, even staunchly free market countries are leaving behind such measures. In the United Kingdom, the conservative government, which adopted an aggressive austerity program in 2010, recently announced a massive increase in its future public spending plans.

Assessing the plans, the Institute for Fiscal Studies suggested that they possibly represent an end or at least a pause to austerity. The Resolution Foundation’s own analysis of the UK’s projected spending stated that it was “likely to head back towards the heights of the 1970s over the coming years.” It’s worth mentioning that the British Conservative Party pursued a very radical neoliberal reform program in the 1980s under the premiership of Margaret Thatcher.

    Knowledge Partners


    School of Business
    American University in Cairo
    AUC Avenue – P.O. Box 74
    New Cairo 11835

    Copyrights © 2017 The American University in Cairo School of Business • All Rights Reserved

    Copyrights © 2017 The American University in Cairo School of Business • All Rights Reserved