Economics of austerity

Paced by housing and energy, the U.K. recovery is likely to accelerate this year and budget deficit projections have declined as well. Unfortunately the European economy remains stagnant though there is some evidence that 'stimulative' policies are gaining traction in Japan. Around the world the idea of “austerity” is fiercely debated. This all makes a reconsideration of the principles that should guide fiscal policy opportune. This requires recognising that policies need to be set in light of economic circumstances.

A prudent government must over time seek to balance spending and revenue collection in a way that assures the sustainability of debts. To do otherwise leads to instability and needlessly slow growth and courts default and economic catastrophe. Equally, however, responsible fiscal policy requires recognizing that when economies are weak and movements in interest rates are constrained as has been the case in much of the industrial world in recent years changes in fiscal policy will have significant effects on economic activity that in turn will affect revenue collections and social support expenditures. In such circumstances, aggressive efforts to rapidly reduce budget deficits may actually backfire, as a contracting economy offsets any direct benefits.

It is a truism that deficit finance of government activity is not an alternative to tax finance or to supporting one form of spending by cutting back on another. It is only a means of deferring payment for government spending and, of course, because of interest on the debt, increasing the burden on taxpayers. A household or business cannot indefinitely increase its debt relative to its income without becoming insolvent, and neither can a government. There is no viable permanent option of spending without raising commensurate revenue.