Eurozone Crisis

Introduction

In the brewing Eurozone crisis, austerity is the buzzword. Austerity has been the main corrective policy advocate by the Troika, made up of the European Commission, the International Monetary Fund and the European Central Bank.

Theoretically, a reduction in government's budget deficit will invoke people's expectations about future higher savings and higher investments. Thus, people will increase spending now and real GDP may not fall. The real issue at hand is whether austerity will curtail growth, such that the slowdown of economies will not justify the long term benefits of having austerity. Therefore, while part of the rationale of choosing this topic is to know more about a relevant issue hogging the headlines, more importantly, it allow us to extend theoretical economic model into real life scenarios.

But, as cliché as it might be, a policy is only as good as its effectiveness. So the question our paper seeks to answer is basically "Do austerities do more harm than good?"

Country Analysis 1: Greece

Year

(*=projection) Fiscal Balance (in % of GDP) Gross Debt

(in % of GDP) GDP Growth (in %) Unemployment

(in %) Gross National Saving (in%)

2009 -15.6 129.0 -3.1 9.5 5.1

2010 -10.5 144.5 -4.9 12.6 4.6

2011 -9.1 165.4 -7.1 17.7 3.2

2012* -7.5 170.7 -4.7 25.1 7.3

2013* -4.7 181.8 0.0 - 9.0

Greece has one of the most ambitious fiscal consolidation plans in the Euro-zone (12.6% goal in fiscal cuts in until 2014). One direct effect is on future expected taxes, T'e. Greece's austerity has heavy emphasis on plans in increasing future taxation, particularly broadening the tax base (eliminating various tax exemptions and reducing number of income tax bands), increasing pension and VAT taxes, and solidarity taxes on personal income(up to 5% increase) . Given the assumption of rational expectation, this may reduce current output through shrinking consumption as citizens expect lower future after-tax labor income, shifting IS curve to the left.

Coupled with the inability of the Greek government to use monetary expansion as counter-policies due to common 'fixed' currency, the Euro, Greece's output level is predicted to actually decline over the next few years. Lower future expected output (equivalently income) Y'e produces more leftward pressure on IS, and is reflected in growing public debt-to-GDP ratio, which is expected to grow to 181.8% in 2013. This reduces investment through pessimism in future expected profits, and may worsen unemployment from the already skyrocketing figure of 25.1%, further dampening households' consumption through lower expected income.

One peculiar finding is that the recessionary effect of Greek austerity measures seems to linger longer than expected. Firstly, our theory suggests that the initial state of government finances contribute greatly to the effectiveness of the fiscal consolidation policies. Greece's fiscal deficit stood at astonishing 15.6% in 2009, unemployment benefits and civil servant salaries are unusually high . Deep fiscal deficit reductions are supposed to improve the general expectations of future variables, hence inducing growth even in the short run.

However, since the first austerity package in 2010, we observe continuous displeasure and riots from the Greek masses . GDP contracted steadily to a new low of -7.1% in 2011, and gross national savings are currently 25% lower than it was in 2009. This may be due to an assumption of our model not binding, which is the assumption of small multiplier. If multiplier is large, reductions in government spending may create severe contractionary effect on output. Credibility and timing of the austerity is also an issue for Greece. Much of the fiscal consolidation is frontloaded by pressure of the troika (in attempt to put debt-to-GDP ratio on a declining path), due to slippages in previous austerity implementation by the Greek government. These factors resulted in economists predicting Greece to delve in recession for at least another year . With additional 13.5 billion Euros of austerity in the next two years, one can only hope that Greece will survive long enough under troika's bailout loan until the long-term benefit of austerity kicks in, if ever.

Country Analysis 2: Italy

Italy has implemented austerity measures amounting to €20 billion in an attempt to reduce its €1.9 trillion debt . Most of the austerity measures to reduce its debt by €20 billion have focused on increasing income tax, consumption tax, and property asset tax , while government public spending is to be reduced marginally. Many economists believe the increased taxes have a larger recessionary effect than spending cuts because it leads to significant reductions in consumption and investment that together constitute a greater portion of demand than government spending.As Italy's austerity measures aim to immediately reduce Italy's deficit, it is not backloadingbut is instead making large cuts in public spending and raising tax rates in the current period. To make matters worse, Bundesbank board member Andreas Dombret has observed that there has been a "profound loss of confidence in markets" . This implies that people do not expect future output to increase significantly and may even be predicting a scaling back of future output. This current contraction of fiscal policydue to Italy's austerity measures, combined with the lack of an offsetting effect of market optimism about the future that would increase current consumption, has led to a reduction in consumption, investment as well as government spending causing an inward shift of the short run IS curve as seen in the graph above.

As the economy was not overheated prior to the austerity measures, the austerity measures have caused Italy's output to fall below its natural level of output. The recessionary effect of austerity has resulted in a 8-year high rate of unemployment at 10.7%, as of August 2012 , as companies cut back production, and in the process retrench workers, in response to