What economists say about Merriam-Webster's word of the year for 2010.

Commentary about business and finance.
Dec. 22 2010 5:53 PM

Austerity Rules

What economists say about Merriam-Webster's word of the year for 2010.

What does austerity really mean? Click image to expand.
What does austerity really mean?

Say what you will about its appeal (or lack thereof) as fiscal policy, but the Top Word of 2010, according to Merriam-Webster, is austerity. The distinction is based on its popularity on the dictionary's Web site, and runners-up were pragmatic, moratorium, socialism, bigot, doppelgänger, shellacking, ebullient, dissident, and furtive. Try using all of those in a sentence.

It makes sense that readers might be confused by the suddenly ubiquitous term, more evocative of great aunts and catechism teachers than taxes and public-sector salaries. The Oxford English Dictionary—apologies, Merriam-Webster, but my heart belongs to one—lists the first definition as "harshness to the taste, astringent sourness." Then comes the common definition: "Harshness to the feelings; stern, rigorous, or severe treatment or demeanor; judicial severity." Only down at the bottom, in section 4b, does the OED get around to something approaching the 2010 vernacular: "Applied attrib., esp. during the war of 1939–45, to clothes, food, etc., in which non-essentials were reduced to a minimum as a war-time measure of economy."

That's not very helpful. So what is austerity, economically speaking? And why did it become so very prevalent in 2010?

In short, austerity budgeting is when a government faces a serious deficit or debt, and attempts to correct it quickly with massive cutbacks in spending and hikes in taxes and fees. Often, the pressure to implement such radical budgeting comes from fears about the bond market. If investors have little confidence in a country's ability to repay its debts, it will cost that country a lot more to borrow money. And if investors have no confidence in its ability to repay, it might become insolvent.

The term came into common use in the 1920s, explains Mark Blyth, a professor of international political economy at Brown. (He's at work on a book titled Austerity: The History of a Dangerous Idea.) "Hume and Smith had nothing to say about austerity," Blyth says, referring to the 18th-century founding fathers of economics. "Being the parsimonious Scots they were, they felt that individuals could be imprudent, but that everybody evens out at the national level."

But that proved not quite true. And in the early 1900s, countries made the first attempts at cutting their way to growth—or at least trying to do so. These early efforts generally resulted in catastrophe. The United States, for instance, attempted austerity under Presidents Hoover and Roosevelt in the 1930s—with the effect of worsening the Great Depression.

Austerity budgeting makes sense when a country is indebted but otherwise healthy and growing. During and just after recessions, however, the calculus is trickier. When demand is weak, governments step in to pick up the slack, through automatic mechanisms like unemployment benefits and with fiscal policy like stimulus spending. A few years after a big recession, demand still might be weak, with unemployment high and businesses hesitating to spend. (Sound familiar?) But the government might be worried about its deficit and the bond market's willingness to buy its debt. That's the situation a number of countries are in right now: unwilling to spend more on stimulating their economies for fear of alienating the bond market. So a few have chosen, or been forced into, austerity.

In exchange for an International Monetary Fund bailout, for instance, Greece cut public employees' salaries, slashed pensions, slapped new taxes on everything from gas to cigarettes, and increased the retirement age. Ireland cut salaries for public employees like nurses and professors. Portugal reduced unemployment benefits, shuttered hospitals, and fired police officers. Britain has promised to cut as many as 330,000 public-sector workers. And the tiny Baltic state of Latvia pushed through the most drastic measures, cutting teachers' pay by nearly half in some cases.

So how has all this austerity budgeting worked? The short answer is: We don't know yet. But the early signs are not encouraging.

The austerity budgeters have continued to see tepid growth or even slides in GDP, as well as real economic pain—joblessness, poverty, slashed social safety-net spending. Adding insult to injury, the bond markets have failed to appreciate their … austerity. For Ireland and Spain, for instance, the cost of borrowing has actually increased. Latvia is one of the very few countries that has seen a drop in borrowing costs and a GDP bounce—though some economists think it might be more of the dead-cat variety. (The country's economy has shrunk by 25 percent since its 2007 high.)

So why didn't the United States have to do what Europe did? (Its policy—which it continued, despite bipartisan protests, in the recently enacted tax-cut bill—is to engage in deficit-spending to keep up demand until unemployment falls and the private sector takes over again.) For one, the bond market treats the United States differently than it treats other countries. The cost of borrowing is very low for Washington, both because the United States looks good compared with Europe and because China and other developing countries like to purchase U.S. debt. In addition, the United States has control over dollars in a way that Athens does not over euros. The United States can devalue its currency and cover debts by printing dollars—something countries in the eurozone just can't do.

Therefore, a number of countries have chosen austerity. But austerity—ahem, eschewing socialism, acting like Hoover's doppelgänger, retaining your bigotry about debt, being ebullient about fiscal belt-tightening and putting a moratorium on unnecessary spending, making furtive any dissident Keynesian thoughts so as to avoid a shellacking by the bond markets—might not be the most pragmatic solution.

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