The Fine Line between Growth and Austerity
The world seems to be spinning out of control as years of excessive growth take their toll. Drastic efforts by industrialized countries, companies, and households to cut back spending are making headlines. Austerity might well make sense today, but it could also trigger negative effects before long – as the extreme opposite of the frenzied spending seen in recent years.
When the proportion of income to expenditure is out of balance and spending exceeds revenue, something has to give. This simple homespun wisdom also applies on a broader basis when we examine the global debt crisis. There is no question that income has to correspond to spending. But in a global economy, it does not have to happen in the same place, or even necessarily at the same time. If expenses and income are not available in the same place and at the same time, credit can be used to bridge the gap.
Otherwise, no economic growth would have been possible during the last 1,000 years. While Robinson Crusoe had to save up the seeds to plant his own field himself, an open economy with multiple players allows surplus assets (i.e. savings) to be exchanged. Interest is the compensation for risk and the reward for not spending in the past.
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Seeking Economic Balance
It is very easy to illustrate this point at the macroeconomic level – initially without making reference to the crisis-stricken Eurozone countries, just for once. For example, a consumption-intensive national economy like that of the US can finance its current account deficit from another national economy, such as China’s, which has earned current account surpluses by having stronger exports than imports (which depend on consumer spending and investments).
In this case, the foreign exchange reserves are invested in US debt obligations, among other instruments. But if the country with the surplus has doubts as to whether the debt obligations can be repaid in full, the perceived risk will increase, calling for higher compensation and triggering a rise in interest rates.
The ability to make good on the credit, or what is known as the sustainability of sovereign debt, depends on the borrower’s potential for economic performance, its levels of debt, and annual borrowing – but also, of course, on the interest rate. If the rate increases astronomically, even the strongest borrower cannot repay its debts.
So austerity is necessary, not in order to maintain a constant balance between income and spending, but so as to guarantee sustainability in other words, to ensure that public finances keep functioning.
Austerity – Why?
This brings us back to the Eurozone. If countries such as Greece, in this specific case, have embarked on a path that leads to unsustainable debt, the steps just described are precisely those that must be taken to restore debt levels to a viable trajectory. Reducing the amount of outstanding debt (a process known as a debt haircut) represents an extreme measure in such cases, because it restricts the country’s ability to return to the capital market by its own efforts for years to come.
The Eurozone countries have made significant progress in reducing their budget deficits over the last two years. The most common consolidation path can be described as a reduction of the ratio between annual borrowing (including interest payments) and the gross domestic product (GDP).
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In these circumstances, it is helpful if the interest rate can be kept constant for the time being, either by intervention on the part of the European Central Bank (ECB) or through a bailout mechanism. At the end of the day, there are only two ways to reduce a deficit: either by significantly reducing new borrowing while maintaining a constant GDP, or by increasing GDP while keeping new borrowing at a constant level.
Austerity – How?
This may sound relatively simple, but there is one major hurdle: How is it possible to curb spending while boosting income? Spain, for example, is currently attempting to master this delicate balancing act. The top priorities are major government spending cutbacks, including salary cuts for public sector staff, and tight supervision of the autonomous regions. Privatizations also channel funds into state coffers in the short term, and they have the added effect of reducing government payroll expenses in the longer term. However, such measures must go hand-in-hand with an increase in state revenues.
It soon becomes evident that the supposedly rapid solution of increasing taxes has the effect of curbing growth. Tax hikes reduce private households’ disposable income, and, all other things being equal, they curtail consumer spending. By the same token – again, all other things being equal – increasing corporate taxes will reduce profits and inhibit job growth. Studies have shown that tax increases during consolidation phases come at a very high cost to growth. To reduce the deficit in such cases, government spending must therefore outrun the decline in growth. Since government spending – such as salaries of public sector employees – is often tied to long-term contracts, it is likely that the private sector (household consumer spending, corporate investments) will adapt more quickly. When the GDP decreases more rapidly than new borrowing, the debt-to-GDP ratio goes up.
On the other hand, growth can provide vibrant impetus for government revenues. Depending on the country in question, however, government revenues respond differently to economic upturns. Only a job market that is as flexible as possible – one that features things like individually negotiable employment contracts, for example – can be infused with impetus for growth.
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Neverthless, nobody can deny that the spending and revenues have a significant influence on our society. Our living standard is associated with government actions. As a result, it is meaningful to compare the government spending and revenues in China and America. Without doubt, the revenues of government is the root of spending of government. In addition, it gives the government the power and the ...
Austerity – and Growth
The way toward a sustainable budget is channeled by two strategies. Government spending cuts are just as crucial a factor as laying the foundations for growth. A too-restrictive fiscal policy, which – especially in the current situation – cannot be offset by a much more expansive monetary policy, can significantly compromise growth and trigger a negative spiral into increasing debt. In the coming years, the financial markets will have to continue critically walking this fine line. Appropriate and adequate asset management should take account of this trend, for example through differentiated weighting of both asset classes and regions
