The austerity and stimulus debates have been reinvigorated by the turn of events in the European economies. The indication is that the two economic ideas are exceedingly disputed yet there is inadequacy in their understanding.
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While the stimulus packages have widely been accepted as the best economic measure during the economic slowdown particularly its application in the US, austerity has raised eyebrows among the economic observers (Krugman, 2010). Many economic pundits argue that austerity is not applicable in the current situation as advanced by many players in the global monetary marketplace.
The major argument is that austerity measures are applicable when the economy is at the pinnacle of the production phase to stop further production and ignite inflation (Krugman, 2010). The argument originates from the Keynesian view. Keynes observed that the state deficit is favorable to the economy during the slowdown particularly when the private sector could hardly create adequate demand to draw out the economy out of a slump.
However, in some quarters, the views on austerity have been challenged by many economic turns of events. The outcome of the 2007/8 financial crisis further put the austerity measures out of economic control. The argument is that austerity measures no longer have the economic intention of stabilizing the macroeconomic indicators (Krugman, 2010).
Rather, it is demanded by the international financial institutions to show that various governments are committed to the management of their deficits, are capable of meeting their debts obligations, and safeguard the interest of sovereign debt investors.
The claim is not the ultimate truth about austerity. In fact, researches indicate that austerity has worked in many instances. In addition, if austerity slows down economic growth as claimed, markets would not be favorable to those economies that have applied the policy. As will be indicated in this article, austerity will not be the ultimate policy to cure the aftermath of the financial crisis but provides a good measure to foster economic growth.
The research findings concerning fiscal austerity and increased tax rates
Studies conducted by Padovano and Galli (2001) used information from the OECD states to indicate that austerity or stimulus, when combined with reduced tax rates, stimulates demand. An increase in demand leads to greater economic growth. The study established that high marginal tax rates, as well as tax progressivity, are inversely related to long-term economic development.
Further, the researchers in a follow-up study found out that an increase in marginal tax rates by about twenty percent leads to a reduction in the yearly economic growth by 0.5 percent.
Moreover, other researchers have also found stronger connections between the tax rates and the rate of economic development. For instance, Engen and Skinner (2006) concluded that a tax change aimed at reducing marginal rates by twelve percent are forecasted to swell the lasting expansion pace by one percent.
Focusing on the corporate taxes, studies by Lee and Gordon (2005), reached the same conclusion using data originated from seventy countries, stating that a reduction of between ten to twelve percent in company taxes increased a country’s growth rate by two to five percent.
The conclusion emphasizes that the increase in growth compounds eventually. For example, an extra one-hundredth increase in growth, compounded over twenty years has the effect of selling a country’s gross domestic product by about twenty-two percent.
A paper by Romer and Romer (2010), developed new measures of economic upsets and came up with conclusions based on tax reforms. The baseline condition recommends that an exogenous tax increase of a percentage GDP have the effect of reducing the real GDP by two percent.
In addition, an exogenous tax increase reduces investment radically. Further, the paper suggests that the production consequences of tax alterations are unrelenting. Indeed, it is evident that tax rules have strong effects on the performance of the economy.
The studies mentioned focus on the multiplier effect on tax rates. The studies indicate that austerity measures combined with reduced tax rate policies stimulate economic growth (Lee & Gordon, 2005). Though the critics of the policy point out some of the conventional Keynesian economic predictions during economic downturns, the studies indicate that the facts being mentioned have been overtaken by events.
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Moreover, the situation in Europe today is different from the 1970s and 1990s when austerity did not actually work. The other fact is that the proponents of austerity measures are the financial institutions that are being accused of putting their interest first. Though this might be true, further studies in the expansionary austerity dispute the critic claims.
Researches on expansionary austerity
Many studies have also challenged the efficiency of conventional Keynesian fiscal incentives during downturns. In other words, a country accruing an escalating public liability burden could gain from a decrease in government expenditure even in the short-run. For instance, economic pundits embracing the business cycle theory clarifies depressions as the stability outcome of the structural alterations in the market.
In this structure, households and firms recognize that all regime expenditures must be paid for either through price rises or taxes to offset the government debts. On that note, changes in household savings through the Ricardian equivalence offset the deficit-financed tax cuts. Consequently, real-business-cycle assumptions indicate that the paybacks of expansionary financial austerity cannot be avoided.
For a case in point, any economic administration with accumulated long-term liability may lead to citizens and other economic players demand its solvency. In such situations, governments have no other option but to increase interest rates. The rise in interest rates results in a vicious cycle.
However, governments are capable of getting reprieve through their bond markets. By implementing politically difficult policy alterations, the government realizes lower interest rates through the bond market. Therefore, servicing of the government debts is lowered to inspire private venture.
The researchers also contend that austerity is very critical in balancing the budget. In addition, it is intended to calm down bond traders as well as the financial institutions. As such, austerity ensures the affordability of public liability. Managing the fiscal debt is simple during times of economic booms since austerity is chosen by the equilibrium between government expenditures and the liability.
The Keynesian economists recognize the need to apply austerity in the business cycles to eliminate inflation. From this viewpoint, austerity is the preferred approach during economic downturns.
The European Central Bank bulletin (2010) clarifies the fiscal consolidations in the EU states centering on the expenditure policies as favorable to spur economic growth. According to the bulletin, around half of the fiscal consolidations in the EU over the past years have been accompanied by improvements in production growth in the short-run comparative to the original point.
Further, David (2010) explains the measures undertaken by Canada in solving the financial crisis. The study points out that the government’s remarkable expenditure slashes, as well as temperate tax increases, promptly solved the monetary crisis in Canada (Crowley et al., 2010).
As a result, Canada recorded a GDP growth of 3.5 percent according to the data from the International Monetary Fund. In addition, the country also experienced increased investment and job creation (Crowley et al., 2010).
Interestingly, the famous Keynesians do not dispute the precision of the narration relating to the success of austerity. However, they contest the relevance of these occurrences to the present state since each of them emphasizes on the equalizing measures particularly decreasing rates of interest and weaker legal tender (Krugman, 2010).
The point is that the sole stirring cases that fiscal stimulus produces a continuous recovery do not occur. Concentrating on the bookkeeping connection between the national reserves and investments, the argument is that government shortages crowd out the personal ventures whereas stimulus policies absorb the reserves and need funding which translates to the displacement of the present utilization of the same finances (Krugman, 2010).
Therefore, austerity is essential to ensure effective spending in the private sector that leads to economic revival. David (2010) argues that inflation is a consequence arising from the bond market that the government is unable to finance its debt in the future.
The expected inflation prompts a run in the currency prior to the crisis leading to a swift increase in the nominal interest rates and price rises. Therefore, it is evident that austerity is significant for the reduction of public liability as well as cools the money market to avert the crisis.
Despite claims by the austerity critics that increase in fiscal spending and the tax rate will stimulate the European economies in the short-run, there are numerous economic and historical literature suggesting that the supply side economics together with austerity founded on tax cuts and increased government spending stimulates the economy in a greater scale in the short-run.
In fact, the economic stimulus is accompanied by the tax cuts contrary to the claims of the critics that increase in taxes spurs the growth of the economy. As indicated in various economic researches, though the findings are not similarly accepted, the proposed Keynesian form of monetary incentive is not strong as alleged. The Keynesian model of increased government spending must be accompanied by the tax cut, a multiplier in the model.
The current prominent Keynesian theorists have neither challenged the above studies on the expansionary austerity nor produced any narratives that challenge its successes.
The argument only centers on its inapplicability on the current situation. The offsetting measures including weaker currency and reducing rate of interest are cited as the main cause of its irrelevance. However, these offsetting measures have been countered through zero-rating interests in the short-term. In addition, net exports cannot be increased globally. Therefore, the expansionary austerity policy misplaced argument is futile.
As indicated in most studies, fiscal stimulus and austerity measures are only applicable in the short-run. Economic policymakers, as well as the academicians, must come up with appropriate models that will ensure sustained growth in the economy.
In other words, the current economic models have not dealt with the aftermath of the 2007/8 financial crisis explicitly. However, there are many success stories of expansionary austerity and fiscal stimulus though the Keynesian critics have invented theoretical reasons to destruct their significance in the current economic situation.
Crowley, B., Lee, R., Murphy, P. & Veldhuis, N. (2012) Northern Light: lessons for America from Canada’s fiscal fix. Retrieved from: http://www.macdonaldlaurier.ca/mli-library/books/northern-light-lessons-for-america-from-canadas-fiscal-fix/
David, H. R. (2010). Canada’s budget triumph. Retrieved from: http://mercatus.org/publication/canada-s-budget-triumph
Engen, E. & Skinner, J. (2006) Taxation and economic growth. National Tax Journal, 49 (4), 617-642.
European Central Bank Monthly Bulletin (2010). Discussion of fiscal consolidation. Retrieved from: http://www.ecb.int/pub/pdf/mobu/mb201006en.pdf
Krugman, P. (2010). Myths of austerity. Retrieved from: http://www.nytimes.com/2010/07/02/opinion/02krugman.html
Lee, Y. & Gordon, R. H. (2005). Tax structure and economic growth.” Journal of Public Economics, 89 (16), 1027-43.
Padovano, F. & Galli, E. (2001). Tax rates and economic growth in OECD countries (1950-1990). Economic Inquiry, 39 (1), 44-57.
Romer, C. D. & Romer, D. H. (2010). The macroeconomic effects of tax changes: estimates based on a new measure of fiscal shocks.” American Economic Review, 100 (3), 763 – 801.