Many governments spend more money then they take in. This is known as deficit spending. This is not necessarily a bad thing, but it is possible for their debt to get so large that they will no longer be able to operate. At least, the cost of borrowing money will be so greatly increased, that it becomes an obstacle. When this happens, countries must take action to get their balance sheets in order.
There are two options: a) raise more revenue and b) reduce spending. In today’s world, most every politician insists that the focus must be on option b. They propose what are known as “austerity measures” which cut government spending. This results in fewer government employees, fewer government benefits and fewer government programs. By reducing the expense of running the government, the government deficit will shrink. At least that is the goal.
Some economists believe that austerity will result in increased economic activity. The "expansionary fiscal contraction" theory argues that a reduction in government spending and taxing will result in increased consumption and long-term growth. The idea being individuals will see the government taking action to reduce their debts and will therefore need less revenue from the citizenry in the future. The citizenry will then feel comfortable spending dollars set aside for future taxes on goods today. The research is split on the issue, as with all things related to economics.
What is the cost of introducing austerity measures? Notwithstanding the expansionary fiscal contraction theory, reductions in government expenditures tend to have immediate, negative consequences for the general economy of a country. This is because it is an integral part of the calculation of gross domestic product, a.k.a. GDP, which is the primary measure of a country’s economic health. The formula is as follows: GDP = Consumption + Investment + Government expenditures + (Exports – Imports). Simply put, if the government spends less money, GDP will go lower. Further, reductions in government welfare programs means fewer individuals will have those funds available to them and therefore will consume less. Further, reductions in government staff means those people will be without jobs/income and will likely consume less. Further, reductions in government subsidy programs mean certain industry, for example alternative energy, will be less economically viable and companies will not invest in developing those technologies as much. Further, reductions in funds for infrastructure projects, for example bridge repair, means fewer jobs available and less consumption by those workers.
It also should be noted that austerity measures tend to have the greatest impact on poorer people. They are the ones who rely on government programs (like welfare) and they are the ones who work jobs that are the first to be eliminated. As evidenced in Spain and Greece, the imposition of austerity measures tends to galvanize the young and workers to express their disdain by protest.
All of that being said, government inaction to cure their budget woes is significantly more problematic. As mentioned before, the cost of borrowing more money to operate will get higher and higher if the markets worry whether a country will be able to pay back their debts. If a country defaults, there is the potential for it to send a ripple throughout the world’s economies. Credit markets would freeze again. Trade and commerce would become incredibly expensive. It is likely the world would slip back into a recession. So governments must take action to cure their budget shortfalls and ensure they have enough to pay off their debtors. Just remember, there is no reason that policymakers should rely exclusively on reductions in government expenditures. They should consider all options, like raising revenue through higher taxes, to get out of the mess they are in.