The piece above by Magnon is about the shortest and most clear about the arguments against austerity under present conditions. These present conditions are:
- The aftermath of a financial crisis, where the private sector is recovering their damaged balance sheets by borrowing and spending less.
- As a result, the economy produces way below capacity, resulting in high unemployment and plants that are not fully used so there is little incentive for business to expand investment.
- The combination of low credit demand (households repairing balance sheets, firms not expanding production capacity) and monetary policy produce very low interest rates.
Under these circumstances (called a balance sheet recession):
- Monetary policy is relatively powerless as even record low interest rates do not revive borrowing and spending by all that much
- Fiscal policy is unusually effective due to the record low interest rates and the lack of 'crowding out' (due to high savings and low credit demand increased public borrowing isn't likely to increase interest rates and 'crowd out' private sector credit demand).
Austerity (reducing public spending and/or increasing tax rates) can easily compound the tepid private spending and have a large adverse effect on economic growth because It cannot be offset by more expansionary monetary policy as interest rates are already rock bottom.
So austerity is likely to have a larger negative effect on economic growth than usual, but there is another effect. The longer the economy produced below full capacity, the more future economic capacity will be damaged and the lower future economic growth will be:
- Low demand and capacity utilization slows business investment, production capacity increases more slowly than would otherwise be the case and the existing capital stock deteriorates as it isn't renewed as fast, slowing productivity growth
- The longer people stay unemployed, the less their chance of future employment, that is, labor also deteriorates slowly.
This hysteresis effect, as it's called, hampers production when demand finally recovers, as it slowly deteriorates existing production factors. Austerity, under present conditions, could therefore have long-run negative growth consequences, and therefore also negative consequences for future tax receipts, in which case it can become self-defeating, that is, not leading to improved public finances.