Monday, November 02, 2015

Defining Austerity

The term "austerity" has an awful lot of people confused, so I thought I'd do a quick post on the subject explaining it from an economic point of view. The first point to get out of the way is that the kind austerity being discussed by and large is _fiscal_ austerity, relating directly to policy decisions by the government on spending and taxation. It's not the only thing we can deem as "austerity", but it's generally what people have meant in discussing it over the last 6-7 years. What follows simplifies the details a little, but makes a pretty good rough guide.

First we need to come up with the concept of aggregate demand (Written as the letter Z). We specify

Z = C + I + G

That is total demand in the economy is equal to demand for private consumption (C), plus investment demand (I), plus government demand (G). We then add total output (or GDP, written as Y) to the mix. Because total demand equals total output we can move on to getting an equation that crops up a lot in economics (the goods market equation in IS-LM):

Y = C + I + G

Finally, we add in taxes, we place taxes next to consumption to denote that they act to reduce consumption:

Y = (C-T) + I + G

Now that we have our equation, we need to start to talk about fiscal policy by looking at the two variables in this equation that are within the gift of the government: government demand (G) and taxes (T). Any government policy that acts to raise Y in this equation, tax cut or spending rise, is fiscal expansion, anything that acts to reduce Y is a fiscal contraction (aka what we can call austerity).

That, in a nutshell is how economist/econoblogger community defines "austerity", although there is a couple of final complications. The first in that GDP (Y) is a moving target that is usually growing at a slow trend rate. In that sense we do need to look at how the two government controlled components (G and T) behave relative to overall growth of output, G growing more slowly than overall output can be considered austerity in this sense (indeed, in order to make this happen you would probably need to make cuts). The second which relates to the moving target nature of GDP is that determining with any precision whether a policy is expansionary or contractionary can be difficult as you can't be sure what GDP growth holds, we can for example guess that the coalition's raising of the tax threshold was expansionary as it was way beyond any regular inflation/wage related expansion but it would be hard to define what the precise figure for said expansion was.