Austerity and the debt spiral

Italy becomes the latest economy to join the austerity bandwagon. Faced with a public debt burden amounting to 120% of GDP and the domino effect of sovereign default threat from the other PIIGS, the Italian government has agreed to a $65 bn austerity program in return for ECB buying Italian bonds to prevent its borrowing costs from rising any further. As part of this, the government would increase taxes and cut local government transfers in an effort to balance the budget by 2013.

I have blogged earlier about the fundamental problem with contractionary austerity policies when the economy is in a deep recession. Far from bringing in the "confidence fairies" and putting the economy back on the recovery path, such policies exacerbate the recession and pushes the economy further down.

In simple terms, during recessions, resources - labour, capital, factories etc - are forced to remain idle and consumers cut down on purchases and businesses on investments. This gets amplified when household balance sheets are bruised, the unemployment rate is very high, and external markets too are in similarly bad shape. Governments typically step in to retrieve such situations with demand management policies. But when interest rates are touching zero-bound and the public debt is raising alarms, conventional monetary policy becomes less effective and there is strong ideological and political push-back on further fiscal stimulus spending.

Into this environment, if austerity programs are introduced, more resources become idle and aggregate demand slumps further. As the economy tanks, tax revenues decline and debt-to-GDP ratios increase and the relative value of the public debt increases. The economy shrinks further and slips down the slippery slope. As the country slips further deep into debt, bond investors start to worry they won’t get their money back. A debt spiral, a vicious circle of sinking confidence, rising borrowing costs and, ultimately, rising debt burdens is the inevitable result.

The Times has an excellent graphic that captures this downward spiral.