As Greece's plan to tackle its economic problems goes before eurozone finance ministers for approval, the question remains whether austerity as demanded by the latter is the right approach.
While many economists argue against it, saying that it curbs economic growth, an analysis by Benjamin Born, Gernot Müller and Johannes Pfeifer concludes that austerity does pay off in the long run. Its conclusion:
Our results have important implications for policy.
• First, whether austerity is painful in the short run depends on the level of fiscal stress.
As spending cuts cause little harm under benign initial conditions, it is advisable to prevent fiscal stress from building up in the first place. Admittedly, more often than not policymakers will have missed this opportunity. As a result, austerity is likely to be painful in the short run and the temptation to renege on debt obligations increases. Because market participants understand this, they demand a higher default premium. A naïve observer may therefore conclude that austerity “is not working”. In this regard, however, our analysis offers a second important insight:
• If policymakers and the electorate show sufficient resolve, carrying through with austerity will eventually be rewarded by better financing conditions. Austerity pays off in the long run.
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