Austerity Measures

The term austerity refers to a set of economic policies that a government implements in order to control public sector debt. Governments put austerity measures in place when their public debt is so large that the risk of default or the inability to service the required payments on its obligations becomes a real possibility.

In short, austerity helps bring financial health back to governments. Default risk can spiral out of control quickly and, as an individual, company, or country slips further into debt, lenders will charge a higher rate of return for future loans, making it more difficult for the borrower to raise capital.

Governments experience financial instability when their debt outweighs the amount of revenue they receive, resulting in large budget deficits.1 Debt levels generally increase when government spending increases. As mentioned above, this means that there is a greater chance that federal governments can default on their debts. Creditors, in turn, demand higher interest to avoid the risk of default on these debts. In order to satisfy their creditors and control their debt levels, they may have to take certain measures.

Austerity only takes place when this gap—between government receipts and government expenditures—shrinks. This situation occurs when governments spend too much or when they take on too much debt. As such, a government may need to consider austerity measures when it owes more money to its creditors than it receives in revenues. Implementing these measures helps put confidence back into the economy while helping restore some semblance of balance to government budgets.

Austerity measures indicate that governments are willing to take steps to bring some degree of financial health back to their budgets. As a result, creditors may be willing to lower interest rates on debt when austerity measures are in place. But there may be certain conditions on these moves.

For instance, interest rates on Greek debt fell following its first bailout. However, the gains were limited to the government having decreased interest rate expenses. Although the private sector was unable to benefit, the major beneficiaries of lower rates are large corporations. Consumers benefited only marginally from lower rates, but the lack of sustainable economic growth kept borrowing at depressed levels despite the lower rates.

A reduction in government spending doesn't simply equate to austerity. In fact, governments may need to implement these measures during certain cycles of the economy.

For example, the global economic downturn that began in 2008 left many governments with reduced tax revenues and exposed what some believed were unsustainable spending levels. Several European countries, including the United Kingdom, Greece, and Spain, turned to austerity as a way to alleviate budget concerns.

Austerity became almost imperative during the global recession in Europe, where eurozone members didn't have the ability to address mounting debts by printing their own currency. Thus, as their default risk increased, creditors put pressure on certain European countries to aggressively tackle spending.

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