By Ben Cohen: The major argument behind implementing austerity measures during an economic crisis is to make sure governments stay credit worthy and are able to borrow from the bond market in the future. Just think of it like you would a personal credit card - if you've been spending too much and can't pay off your debt, your credit rating goes down. Until you cut your living costs, pay off your debt and consistently show good financial behavior, your ability to borrow money is severely hampered and you won't be able to borrow big sums to buy houses/cars/college educations etc in the future.
It seems like a perfectly reasonable rationale for a government to cut spending in order to restore financial stability during a crisis.
Except it isn't. And here's why.
When dealing with national economy, the credit card analogy doesn't hold up because there are so many interconnected variables. When an economy is in recession, people lose jobs and stop earning money. When they stop earning, they stop spending and the economy contracts even more as demand for goods goes down and industry stops producing. As the economy contracts and unemployment rises, governments take in less revenue from taxes and spend more on welfare, creating higher levels of debt. If the debt increases and economies show no sign of recovering, countries run the risk of having their credit downgraded making future borrowing more costly.
As we have seen across Europe, cutting government spending has actually made the situation infinitely worse despite incessant rhetoric from conservatives that it would fix the crisis. Creditors see no end in sight, and countries continue to have their credit ratings slashed despite extreme austerity measures. Writes Joe Weisenthal at Business Insider:
The fact of the matter is that there's no example in Europe, yet, where the bond market has rewarded austerity.
Take Spain: It recently announced fairly severe reform plans, and yields just shot higher.
The truth is that the bond market has reacted overwhelmingly negatively to countries that have slashed government spending in order to please it. Paul Krugman posted the following chart showing the Credit Default Swap (CDS) spread (which moves closely with the bond spread) in Ireland, a country that was subjected to extreme austerity measures:
As you can see, the cost of insuring Irish debt against default has risen exponentially. The lesson? Cutting spending does not increase credit worthiness - it decreases it.
It is too early to tell how the bond market and the credit agency Standard and Poor's will react to governments that are committed to increasing spending - Francois Hollande's victory in France was supposed to send the bond market into turmoil, but the evidence thus far shows nothing much has happened.
And one thing is for sure - it couldn't be worse than before given the trajectory of the French economy under Sarkozy's austerity regime.