The austerity measures and tax increases implemented from 2010 onwards did not reduce sovereign debt in Spain, Portugal and Italy as anticipated. Instead, they were among the forces that drove the three economies back into recession. Contrary to popular opinion, the failure of the consolidation strategy is not the result of a lack of the will to reform on the part of the relevant governments. Actually, the dramatic spending cuts and tax increases prevented the reforms that were implemented from unfolding their full effect. That is the result of a new study by DIW Berlin that examined the effects of the austerity policy in Spain, Portugal, and Italy for the period 2010 to 2014.
According to the study, the enormous private household debt in the three countries played a key role in the policy's negative impact on growth. In Spain, for example, private households had to pay more to service their debt as the result of stricter financing conditions. As a result, private household debt fell from 87 percent of GDP in 2007 to 60 percent in 2014. "Private households used a large proportion of their disposable income to pay off outstanding debt and had less money available for consumption," said author Mathias Klein. "Then the government raised taxes and cut spending, which only amplified the effect. The sharp drop in private consumption reduced GDP and the already high unemployment level rose again."
Moderate consolidation preferable
The austerity policy also amplified the effects of the recession by reducing long-term output potential. The measures implemented further throttle employment, which is already shrinking in a recession, and create more long-term unemployment. The job market loses key know-how and labor potential diminishes. Austerity measures also amplify the drop in company spending on research and development, which in turn has a negative impact on output potential. "Under conditions like these, economies can only recover very slowly," said author Philipp Engler. "And the longer the recession, the more the public budget suffers. In such an environment, budget consolidation has no chance of success."
The two authors of the study conclude that a balanced mixture of policies such as moderate austerity measures, structural reform, and budget reallocation in favor of investment are preferable to far-reaching budget consolidation.
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