The false economy of austerity

Trust is a central part of any well-functioning economy. According to research, trusting others is essential to building social capital, increasing per capita income, and for sustainable economic growth. The trust we place in our public and private institutions is equally as important. It means that regardless of the ups and downs of an economic cycle, the system itself is never called into question, and we as a society continue to have faith in the actions and credibility of our governments, banks and other institutions.

But the ongoing economic crisis is testing this, with levels of trust falling to record lows. I see two reasons for this: people are increasingly disillusioned with some key institutions in the economic system and are equally disappointed with the way the crisis has been handled.

Among those economic institutions whose credibility has been called into question are banks and credit-rating agencies, as well as financial watchdogs and even governments. Market failures have also had a role to play. Although the successful functioning of the entire financial system depends on trust in these institutions, today they inspire very little confidence.

However, the cause of most disillusionment has been the high – and unevenly distributed – price paid for dealing with the crisis, especially in Europe. The failures and distortions in the functioning of financial markets are largely to blame, but the economic policies implemented in the wake of the crisis have also contributed. Austerity measures, in place across the entire Eurozone, have led to increased unemployment rates and yet have done little to decrease the financial vulnerability or national debts of those countries that have applied them with the most zeal.

The most shocking illustration of the uneven price being paid is the growth in income disparity, with the gap between rich and poor becoming ever wider. This is not a new trend. Analyses from the Organisation for Economic Co-operation and Development (OECD) and the World Bank based on data up until 2008 showed that in the decade leading up to the crisis, income inequality was increasing. Household debt for those in medium to low-level income brackets increased, particularly during the years of the Great Moderation, and the pay gap grew. It is these same people who have been most badly affected by the unemployment crisis and who are no longer in a position to negotiate on salaries.

This segment of the population has been hardest hit by the austerity measures, which have been much harsher than in any previous crisis. The cuts in public spending and reductions in unemployment benefits, particularly from 2011, have affected the most vulnerable in society. The same period saw the weakening across the whole Eurozone of automatic stabilizers – those measures, such as taxes and welfare – that are meant to kick in to stop an economy going into free fall.

As has been shown with previous financial crises, there is a clear link between the policies of financial consolidation – measures put in place to reduce government deficit and debt – and the growing income gap. These policies have been more severe and indiscriminate than ever before, aggravating the problem all the more.

As President Obama recently recognized, “dangerous and growing inequality” in the United States has resulted in a “lack of upward mobility”. This stagnation in social mobility has been even more evident in the Eurozone’s periphery countries. Cuts to education budgets not only affect social mobility and equality of opportunities, but they also threaten economic growth. As this year’s Global Competitiveness Report  noted, education is one of the key determiners of a country’s competitiveness. As more and more cuts are made to schools, education and research, the competitive capacity of an economy is eroded.

High levels of inequality do not make economic sense. Growing inequality is giving rise to inefficiencies that impact an economy’s long-term and sustainable growth. Policy-makers need to bear this in mind when planning the next round of measures to tackle the ongoing crisis in Europe.

Author: Emilio Ontiveros is professor of business economics at the Autonomous University of Madrid and chairman of Afi, an economic and financial consultancy. His latest book, Global Turning Points, is co-authored with Mauro Guillén. 

Image: A woman sits on her suitcase as she waits for a train in Sevilla, Spain REUTERS/Marcelo del Pozo