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Austerity under Attack

BRUSSELS – Europe seems to be obsessed with austerity. Country after country is being forced by either the financial markets or the European Union to start cutting its public-sector deficit. And, as if this were not enough, 25 of the 27 EU member states have just agreed on a new treaty (called a “fiscal compact”) that would oblige them never to have a cyclically adjusted budget deficit of more than 0.5% of GDP. (For comparison, the United States’ budget deficit in 2011 was close to 8% of GDP).

But, as the European economy risks falling into recession, many observers are asking whether “austerity” could be self-defeating. Could a reduction in government expenditure (or an increase in taxes) lead to such a sharp decline in economic activity that revenues fall and the fiscal position actually deteriorates further?

This is highly unlikely, given the way our economies work. Moreover, if it were true, it would follow that tax cuts would reduce budget deficits, because faster economic growth would generate higher revenues, even at lower tax rates. This proposition has been tested several times in the US, where tax cuts were invariably followed by higher deficits.

In Europe, the concern today is instead with the debt/GDP ratio. The worry here is that the GDP drop resulting from “austerity” might be so large that the debt ratio increases. This matters, because investors often use the debt ratio as an indicator of financial sustainability. Thus, a lower deficit might actually heighten tensions in financial markets.