Defining Austerity

In my recent talk in Dublin, I defined fiscal austerity in a way that is not generally applied, but which I think makes sense. The most common usage is simply an attempt to reduce the budget deficit by cutting spending or raising taxes. The problem with that, as I remember Nick Rowe complaining, is that it becomes identical to the term fiscal consolidation. We could say that austerity is just lots of fiscal consolidation, but that seems weak.

Common usage tends to assume that austerity does some harm: not just to the individuals affected by any cuts or tax increases but for the economy as a whole. Indeed if you look at what Google says when you ask for a definition, we get:

difficult economic conditions created by government measures to reduce public expenditure.

That is different from fiscal consolidation, because consolidation in itself need not lead to ‘difficult economic conditions’. If fiscal consolidation is offset by monetary expansion, there is no reason for the economy as a whole to experience any difficulties.

What I suggest is making this definition a little more precise. I want to define austerity as

fiscal consolidation that leads to a significant increase in involuntary unemployment, or perhaps more formally but less colloquially as leading to a noticeably more negative output gap.

If you think this is what most economists mean in practice, I would agree. But they do not always define it this way, even when they should know better. In addition, under my definition the term ‘expansionary austerity’ would make no logical sense, but the term is widely used. Last and probably least, Wikipedia define it as fiscal consolidation rather than the way I suggest.

The advantage of my definition is that I am able to make two clear statements. First, for the global economy or for an economy with its own central bank and floating exchange rate, austerity is generally completely unnecessary, because fiscal consolidation can be delayed until a time when monetary policy is capable of offsetting it. This means that austerity could have been completely avoided over the last five years in the UK, US and the Euro area as a whole.

Second, for a member of a monetary union which requires more fiscal consolidation than union members on average, austerity will follow fiscal consolidation, but only to the extent that it enables the internal devaluation necessary to bring about the real depreciation required to offset that consolidation. Austerity will only be limited in this way if the union’s central bank follows appropriate policies. It seems highly likely that excessive austerity occurred in the Eurozone periphery because the ECB delayed introducing these appropriate policies.

To see me give chapter and verse justifying these statements, you will have to wait until I write up the paper!

This post was first published on Mainly Macro