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U52031 Macroeconomics 2

“Austerity economic policies in the Eurozone: What are

the Macroeconomic effects?”

Dr. Emmanouil Trachanas

Word Count: 1,498

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1.0 Introduction Austerity, the use of contractionary fiscal policy, has become a common reaction following the

Eurozone Crisis beginning in 2009. While the reductions in government expenditure and

increases in tax revenue will lessen budget deficits, the costs of such policies can be seen to

outweigh the benefits. The rationale, effects and results of austerity will be examined through

macroeconomic analysis of the Eurozone crisis.

2.0 The Rationale for Austerity At the beginning of the Eurozone crisis, many European leaders believed that the crisis

stemmed from fiscal recklessness in the peripheral countries1 however such budget deficits,

except in Greece, were a symptom, not the cause of the Eurozone crisis (Duprat, 2013).

However, strict austerity was enforced in peripheral countries in order to reduce public and

private sector debt as well as increase competitiveness (Flassbeck and Lapavitsas, 2013).

Additionally, austerity measures were applied across all Eurozone countries and the level of

enforcement as well as the effects of such policies were region specific2.

3.0 The role of the European Central Bank (ECB) When austerity measures were implemented, the ECB provided liquidity to the European

banking system by buying debts in order to sustain the availability of credit (Micossi, 2015).

Such actions were taken with the hope of stimulating growth in investment however these new

liquidities were hoarded by banks in order to protect against future shocks (De Grauwe, 2014).

Consequently, as the availability of credit to the private sector remained stagnant, the increase

in the money stock was not transmitted to the real economy thus the level of output and prices

remained unchanged. Therefore, the Eurozone was in a liquidity trap with interest rates nearly

zero and monetary policy being ineffective in enhancing growth.

However, in early 2015, the ECB applied quantitative easing, an unconventional method of

purchasing government securities, and securities in other markets, in order to increase the real

money supply. While the effects have not yet been fully recognized, the objective of quantitative

1 The peripheral countries include Greece, Portugal, Ireland, Spain, Ireland and Italy. 2 The adoption of austerity within the Eurozone was divided by regions. For instance, the peripheral countries were advised to implement stricter austerity measures, as they did not follow the Stability and Growth Pact prior to the crisis, while Germany and other countries in the north had less drastic implementation of such (Andini and Cabral, 2012).

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easing is to stimulate investor confidence by increasing the inflation back towards the ECB’s

goal of 2% in the medium term (The Economist, 2015).

3.0 Macroeconomic analysis of Austerity Policy When applying austerity, both the government expenditure multiplier as well as the tax multiplier

must be taken into consideration when understanding austerity’s effects on a change in the level

of output of each country. The equations for both multipliers are provided below;

The Tax Multiplier

∆T× $%&'($%&'

= ∆Y.

The Government Expenditure Multiplier ∆,

(($%&')= ∆Y.

As shown by the equations above, the effects on the level of output are greater when alterations

occur to government expenditure instead of taxes. Using the IS-LM3 model and the AS-AD4

model, the effects of austerity are examined in Figure 1 below. As austerity may include a

combination of both public spending reduction and increases in tax revenue, Figure 1 assumes

that both occur. Additionally, as investment was not boosted by the action of the ECB in the

Eurozone, investment will be held constant in Figure 1.

Results of a decrease in Government Expenditure (G) in the Short Run

As G positively effects the level of output in an economy, a decrease in G will negatively impact

GDP, shifting the IS curve to the left. This occurs as the economies planned expenditure

decreases as a result of the change in G. Additionally, as the money demand depends

positively on output and the money supply remains constant, the decrease in money demanded

in the economy will lead to a reduction of the interest rate. As the price level remains constant in

the short run, reducing government expenditure will lead to a fall in the aggregate demand,

reiterating the decrease in output below the natural level of the economy.

3The IS-LM model shows the combinations of the interest rate (r) and level of output (Y) that are consistent with the good ands services market (IS) and well as the market for real money balances (LM). The LM curve is produced using: (M/P) = L(r,Y). The IS curve is produced using: Y= C(Y-T) + G + I(r). 4 The AS-AD model shows how the price level (P) and output (Y) are determined. The AD curve shows relationship of the price level and quantity of output demanded at (P). In the short run, prices are assumed to be stuck while in the long run prices are flexible and aggregate demand doesn’t affect output.

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Figure 1: Effects of Austerity Source: (Author, 2016)

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Results of an increase in Taxation (T) in the Short Run

As T is negatively correlated to consumption, an increase in T will lead to a decrease in

consumption as household’s disposable incomes are reduced. This decrease in consumption

will decrease the overall level of output in the economy, thus reducing the interest rate and the

aggregate demand at the given price level.

Results of Austerity in the Long Run

While GDP contracts in the short run, as time progresses prices will adjust in order to satisfy full

employment and the natural level of output. This is shown in Figure 1 by the downward shift of

SRAS1 to SRAS2. Once prices decrease, the real money balances will increase, shifting the LM

curve to the right. Therefore, as the economy returns to equilibrium, the natural level of output

and full employment will be reinstated at a lower price level and a lower interest rate. This is

most likely to be the result of austerity in the Eurozone.

4.0 The Implications of Austerity Policy in the Eurozone As Investment remained stagnant, the effects of austerity were more likely to result in a decline

in GDP, an increase in unemployment and lower wages in the Eurozone (Lavapitsas et al.,

2010). For the majority of the countries in the Eurozone this was the case, however there were

exceptions. Austerity was not as successful in the peripheral as it was in the north5 due to

variations in the multipliers of the countries who applied austerity (OFCE, 2014).

Confidence and Investment

These austerity policies rest on the hope that as public debt decreases, confidence will expand

in order to increase private expenditure. Accordingly, the increase in investment will prevent the

reoccurrence of a recession as investment will lead to economic growth, canceling the

diminishing effect of decreased public expenditure and increased tax revenues. Unfortunately,

in Europe, confidence has not increased (Figure 2), therefore the results of austerity policy do

not meet the expectations of those who enforced them.

5Countries that are suggested to be a part of the north would be Germany, France, Austria, Belgium and the Netherlands.

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Public Debt and GDP

As the peripheral enforced much stricter forms of austerity than the north, the changes in

expenditure and taxes were greater, thus the peripheral’s application had a larger negative

impact on output as shown in Figure 3. Those who implemented austerity with greater severity

had weaker growth and higher debt ratios (Busch et al., 2013). Therefore, while austerity

measures decreased the public debt in Eurozone countries, a consequence of such has been

the reduction in GDP. Since 2008 the public debt ratio in the Eurozone has continued to rise, as

shown in Figure 4, thus while the government can decrease absolute debt through austerity

policies, the ability to pay the remaining debts decrease. In order to finance the remaining debts,

countries must increase competitiveness by lowering production costs (Gros and Maurer, 2012).

Figure 2: Confidence in the euro area Source: (OFCE, 2014, p.18)

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Figure 3: GDP per capita in euro area Source: (OFCE et al., 2014, p.24)

Figure 4: Public Debt in % of GDP Source: (Duprat, 2013, p.5)

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Competitiveness

Many uncompetitive countries in the Eurozone were advised to implement Germany’s strategies

of export led growth in order to recover competitiveness (Zezza, 2012). Therefore, peripheral

countries resorted to internal devaluation which included lowering national wages and reducing

employment protection relative to the north (Busch et al., 2013). These reductions in

government expenditure have increased the competitiveness of peripheral countries due to

“lagged productivity growth” which decreased unit labour costs (Duprat, 2013, p.4).

Recession

While these countries increased competitiveness, peripheral countries were still unable to

encourage economic recovery. As many countries were unable to stimulate growth after the

application of austerity, the Eurozone fell back into recession in 2012 (Truger, 2013).

Unemployment

A consequence of austerity in the Eurozone has not only been slower economic growth but also

higher unemployment. Figure 5 shows the effects of austerity policies on employment within the

Eurozone. While the rise in unemployment is partially due to the Eurozone crisis, austerity

policies have emphasised the decrease in employment rates. However, Mario Draghi6 has

openly stated that the negative effects of austerity in the short run must be accepted in order to

obtain economic development sustainability in the long run (Busch et al., 2013). However, as

youth unemployment continues to rise (Figure 6) particularly in peripheral countries such short

term negative effects are likely to have long term consequences in regards to society and the

economy (Koutsampelas and Polycarpou, 2013).

6 Mario Draghi is the president of the European Central Bank.

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Figure 5: Employment rate in the Eurozone Source: (Zezza, 2012, p.39)

Figure 6: Unemployment rates of young people under 25 in GIPS states, 2008 and 2012 (%) Source: (Busch et al., 2013, p.9)

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5.0 Conclusion Austerity has lowered public debt and increased competitiveness within the countries who

applied it, yet the social economic consequences have been significant in the short run. If

austerity continues, moderate and flexible implementation should be considered in order to

address the structural issues of each individual state, instead of a ‘one size fits all’

implementation. As austerity has negative impacts, the monetary environment must be able to

support growth suggesting the need for a more active ECB (international Monetary Fund, 2012).

A great contributor to the Eurozone crisis was the macroeconomic policy framework of the

European Monetary Union itself and therefore reforms should be made to the Stability and

Growth Pact which suggested the need for strict austerity (Andini and Cabral, 2012). Therefore,

while austerity has met the objectives to lower the public debt within countries, the spillover

effects suggest the costs outweigh the benefits. Future implementations of austerity must take

into consideration the cases of the Eurozone and ensure the ability to offset the costs with

support of monetary policy.

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