A general theory of austerity

This working paper takes a look at austerity and tries to explain why it happened. Was austerity an unfortunate accident, or is there a more general political economy explanation for why it occurred? Answering this question is vital to avoid the next global recession being followed by yet more austerity, says author Simon Wren-Lewis.

Austerity is a fiscal contraction that causes a significant increase in aggregate unemployment. For the global economy, or an economy with a flexible exchange rate, or a monetary union as a whole, an increase in unemployment following a fiscal consolidation can and should be avoided because monetary policy can normally offset the demand impact of the consolidation.

According to the author, the tragedy of global austerity after 2010 was that fiscal consolidation was not delayed until monetary policy was able to do this. An individual member of a currency union that requires a greater fiscal contraction than the union as a whole cannot use its own monetary policy to offset the impact of fiscal consolidation. Even in this case, however, a sharp and deep fiscal contraction is unlikely to be optimal. Providing this economy is in a union where the central bank acts as a sovereign lender of last resort, a more gradual fiscal adjustment is likely to minimise the unemployment cost.

As the theory behind these propositions is simple and widely accepted, the interesting question is why global austerity happened.