Austerity Measures: Definition, Examples, Do They Work

How and Why They Were Used in the U.S., Europe and Greece

Austerity measures prompt greek riot
A protester uses molotov cocktails against riot police during May Day protests on May 1, 2010 in Athens, Greece, angered by the harsh austerity measures demanded by the EU. Photo: Milos Bicanski /Getty Images

Definition: Austerity measures are reductions in government spending, increases in tax revenues or both. These oftentimes harsh steps are taken to lower deficits and avoid a debt crisis. Governments are unlikely to use austerity measures unless they are forced to by the bond market or other lenders.

Austerity measures usually target the following spending programs:

  • Limiting the terms of unemployment benefits.
  • Extending the eligibility age for retirement and health care benefits.
  • Reduce government employees' wages, benefits, and hours.
  • Cut programs for the poor.

Austerity measures also include these tax increases:

  • Increasing value added taxes (VAT).
  • Raising income taxes, especially on the wealthy.
  • Targeting tax fraud and tax evasion.
  • Privatization, which is selling government-owned businesses. These are usually industries that are considered vital to the state's interest, such as utilities, transportation, and telecommunications.

Other austerity measures seek to reduce regulations that protect workers to lower business costs:

  • Remove some of the protections against wrongful terminations.
  • Lower or eliminate the minimum wage.
  • Increase workers' hours.

Why Are Austerity Measures Used?

Countries use austerity measures to avoid a sovereign debt crisis. That's when creditors become concerned that the country will default on its debt.

It usually occurs when the debt-to-GDP ratio gets above 90%. That means the debt is almost as much as the country's economy produces in a year. Creditors then start demanding higher interest rates to compensate them for the higher risk.

Higher interest rates mean it costs the country more to refinance its debt.

When it reaches a point when it realizes it can't afford to keep rolling over debt, it may turn to other countries for loans, or to the International Monetary Fund. In return for the bailouts, these new lenders require austerity measures. They don't want to just bankroll continued spending and unsustainable debt.Investors' fears become a self-fulfilling prophecy.

Austerity measures are also used to restore confidence in the way a government manages its budget. The proposed reforms create more efficiency and support a stronger private sector. For example, targeting tax evaders brings in more revenue while supporting those who DO pay they taxes. Privatizing state-owned industries can bring in foreign expertise, encourage risk-taking and expand the industry itself. Instituting a VAT reduces exports by making them more expensive. This protects local industries, allowing them to grow and contribute to economic growth.

Examples 

Greece's austerity measures targeted tax reform. This included a reorganization of the revenue collection agency to crack down on evaders. The agency targeted 1,700 high-wealth and self-employed individuals for audits. It also reorganized, reduced the number of offices, and set performance targets for managers.

Other specific measures included:

  • Reduce overall government employment by 150,000.
  • Lower public employees' wages by 17%.
  • Reduce pension benefits above €1,200 a month by 20 - 40%.
  • Raise property taxes by €3-16 per square meter.
  • Eliminate heating fuel subsidy.

The government agreed to privatize €35 billion in state-owned assets by 2014 and sell an additional €50 billion in assets by 2015. For more details, see IMF Memorandum.

Layoffs, tax hikes, and reduced benefits curbed economic growth.  By 2012 Greece's debt-to-GDP ratio was 175%, one of the highest in the world. Bondholders had to accept a 75% reduction in what they were owed. Greece's recession includes a 25% unemployment rate, political chaos, and a weak banking system. To find out why this happened, see What Is the Greece Debt Crisis?

European Union (EU) - The Greek debt crisis soon spread to the rest of the eurozone, since many European banks had invested in Greek businesses and sovereign debt.

Other countries, like Ireland, Portugal, and Italy, had also overspent, taking advantage of low-interest rates as eurozone members. The 2008 financial crisis hit these countries particularly hard. As a result, they needed bailouts to keep from defaulting on their sovereign debt.

Italy - In 2011, Berlusconi increased healthcare fees, and cut subsidies to regional governments, family tax benefits and the pensions for the wealthy. He got voted out of office. His replacement, Mario Monti, raised taxes on the wealthy, raised eligibility ages for pensions, and went after tax evaders.

Ireland - In 2011, the government cut its employees pay by 5%. It reduced welfare and child benefits and closed police stations.

Portugal - Cut wages by 5% for top government workers. Raise VAT by 1%, and taxes on the wealthy. Cut military and infrastructure spending. Increase privatization.

Spain - Freeze government workers' salaries and reduce budgets by 16.9%. Raise taxes on the wealthy, and increase tobacco taxes by 28%.

United Kingdom - Eliminate 490,000 government jobs, cut budgets by 49% and increase the retirement age from 65 to 66 by 2020. Cut the income tax allowance for pensioners, reduce child benefits and raise tobacco taxes.

France - Close tax loopholes. Withdraw economic stimulus measures. Increase corporate taxes and the wealthy.

Germany - Cut subsidies to parents. Eliminate 10,000 government job. Raise taxes on nuclear power. (Source: BBC, EU Austerity Drive Country by Country, May 21, 2012)

For background on causes, see Eurozone Crisis.

United States - Although it was never called by the name "austerity measures," proposals to reduce the U.S. national debt took front stage in 2011. A stalemate over these austerity measures actually created the U.S. debt crisis.. spending cuts and tax increases became an issue in the U.S. debt crisis. Congress refused to approve the FY 2011 budget in April 2011, nearly shutting down the government. Disaster was averted when some spending cuts were agreed upon. In July, Congress threatened to default on the U.S. debt by not raising the debt ceiling. Disaster was again averted when the two parties agreed to a bipartisan Commission to study the matter. Congress also imposed a budget sequestration if nothing were resolved. This mandatory 10% budget cut would occur, along with tax hikes, a situation known as the fiscal cliff. It was resolved with a last-minute agreement that delayed sequestration, raised taxes on the wealthy, and allowed a 2% payroll tax credit to expire. For more, see Fiscal Cliff 2013.

Do Austerity Measures Work?

They usually don't work, because they also reduce economic growth, often making the debt worse. In 2012, the IMF released a report that stated the Eurozone austerity measures may have slowed economic growth and worsened the debt crisis. However, the EU defended the measures, saying they restored confidence in how countries were being managed. For example, Italy's budget-cutting calmed worried investors, who then accepted a lower return for their risk. Italy's bond yields dropped, and the country found it easier to roll over short-term debt. (Source EU Observer, Rehn Rebuffs IMF Criticism, January 11, 2013)

However, the timing of austerity measures is everything. When a country is struggling to get out of recession, then lowering government spending and laying off workers will reduce economic growth while increasing unemployment. That's because the government itself is an important component of GDP. Likewise, raising corporate taxes when businesses are struggling to reduce costs will only lead to further layoffs. Raising income taxes will take money out of consumers' pockets, giving them less to spend.

The best time for austerity measures is when the economy is in the expansion phase of the business cycle. That will slow growth down to a healthy 2-3% rate, and avoid a bubble. At the same time, it will reassure investors in public debt that the government is fiscally responsible.