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Austerity and the ‘Zero Lower Bound’

Should a government treat its debt in the same way as a household? If we ‘max out our credit card’ then we have little choice but to reduce spending immediately, but is this the same for a government? Have indebted governments in Europe been correct to impose ‘austerity’ on their populations by cutting expenditure on services and benefits?

Why might governments be different? For a start, governments can decide (within feasible limits) their own level of income through taxation. Secondly for governments and the Eurozone the Bank of England (BofE) and the European Central bank (ECB) can adjust financial burdens relating to the currencies they control. Lastly, investors at home and abroad are usually very willing to lend to governments and so to hold bonds issued with the backing of a sovereign nation.

Most economists would agree that the current levels of government debt in the UK and several other European countries need to be decreased eventually – the question is over the timing, since these economies are currently performing poorly (their national income per head is relatively low and is rising only slowly). If this poor performance is not going to be affected, or might even be improved (by releasing resources for private spending) by reducing government spending, then the sooner this debt is paid down the better so as to reduce interest payments – just as it is with our credit card.

If national income or GDP is given by the equation Y = C + G where C is consumption and G government expenditure, then the effect on GDP of a higher level of G depends on the response of C. At one extreme, foreseeing that higher government spending will be matched by an increase in taxation now or in the future, consumers might cut their own spending by exactly the level of the expenditure. GDP will remain unchanged. Even if this foresight is imperfect, or if consumers wish to avoid the impact of immediately cutting spending (consumption-smoothing), the reaction of an independent inflation-targeting central bank (as the BofE and ECB are) will normally be to raise interest rates and largely offset any stimulating effect.

One of the features, however, of the UK and Eurozone economies of the last few years has been the need for the BofE and ECB to set very low interest rates, so low in fact that they are at their ‘zero lower bound’ (ZLB). This means that not only is there no further scope for monetary policy to stimulate the economy, but also that there is much less likely to be an immediate increase in interest rates in response to higher government spending.

Another potentially important impact of government expenditure when the economy is performing poorly is to reduce unemployment, not only of people but also of other resources, since there is strong evidence that both human and physical capital deteriorate when underutilised. This effect is referred to as ‘hysteresis’.

Taken together these factors may mean that ‘austerity’ is the wrong policy until economic conditions improve.

Dr Diarmid Weir- Tutor Alternative Approaches to Macroeconomics