In the current global financial crisis, austerity has become a term of abuse -- one that connotes unnecessary pain and suffering on the part of already-hurting citizens. But that couldn't be further from the truth. What austerity actually means is "measures to reduce a budget deficit" or responsible fiscal policy. And that's hardly the only misconception that has clouded our economic thinking of late.
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Although you'd never know it, the so-called global financial crisis is really a public debt crisis -- and the countries that have reigned in their spending are now growing briskly while the profligate founder. Here are five other myths about austerity that have muddied the waters.
"Growth Requires Fiscal Stimulus."
Wrong. In fact, the opposite is true. Sustainable long-term economic growth requires sound public finances as well as capital, labor, human capital, technology, and strong institutions. British economist John Maynard Keynes, the original proponent of stimulus spending, argued in The General Theory of Employment, Interest and Money that classical economic theory is "applicable to a special case only" and "that the duty of ordering the current volume of investment cannot safely be left in private hands." But stagflation in the 1970s taught us that the relevance of Keynesianism was limited to brief periods of recession. Even Keynes envisaged that budgets should be balanced over the course of the business cycle.
For a fiscal stimulus to be permissible there must be what economists call "fiscal space" for it. In other words, the public debt accrued through stimulus spending must be sustainable. The trouble is, fiscal space is difficult to establish, and it's typically much smaller than we think. During a severe financial crisis, moreover, public debt usually doubles, meaning that there is virtually no fiscal maneuverability. By the end of 2011, for example, eurozone public debt averaged fully 98 percent of GDP, and by the end of 2012, the six biggest Western economies had the following debt-to-GDP ratios: 83 percent in Germany, 89 percent in Britain, 90 percent in France, 107 percent in the United States, 126 percent in Italy, and 237 percent in Japan. None of these countries has any fiscal space.
Given this reality, the main objective of fiscal policy should be to contain public debt, all the more so because of its negative impact on growth. According to economists at the University of Massachusetts, GDP growth falls substantially -- and predictably -- with rising public debt. When a country's debt-to-GDP ratio sits between 60 and 90 percent, they note, average annual real GDP growth is close to 3.2 percent. Where the debt-to-GDP ratio falls in the 90 to 120 percent range, average real GDP growth is 2.4 percent. And when the ratio is between 120 and 150 percent, average growth is a sluggish 1.6 percent.
But it's not just public debt that needs to be taken into account when considering fiscal stimulus -- access to international financing is also critical. Small countries with illiquid bond markets can lose such access at minimal levels of indebtedness, as Latvia and Romania did in 2008, when their ratios of gross public debt to GDP were just 20 and 13 percent, respectively. Despite this cautionary tale, however, the IMF in 2008 and 2009 urged Cyprus, Slovenia, and Spain to pursue fiscal stimulus, wrongly claiming they had fiscal space. That unfortunate advice contributed to pushing all three countries into financial jeopardy. So far, nine out of 27 EU member countries have faced sharp output falls and financial stabilization programs because of irresponsible fiscal policy.
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