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I think it’s time for Austerity 101!

Austerity refers to when governments have to cut back on their spending, in order to prove to their creditors that they will be able to pay back their loans.

Remember, most countries, especially in the Western world, practice deficit spending. This is the act of financing government spending through the use of borrowing, primarily through selling government bonds.

However, when concerns rise whether the borrowing country can actually repay its loans, governments are forced to implement programs to stop spending. They do this in order to reduce the deficit, while also trying to reduce fears of a debt default. Such plans can include reducing the pay of government officials or hiking taxes.

Let’s look at Greece, our favorite debt-ridden nation, as an example. More than a month ago, the Greek parliament approved an austerity plan designed to help the Greek economy pull out of debt. This three-year program of austerity measures is targeted at saving around 30 billion EUR, roughly 11% of Greece’s GDP.

In addition, it also involves wage cuts for public servants and tax hikes – the classic double whammy on paychecks!

Germany, euro zone‘s largest economy, is set to try this new austerity fad too. According to their finance moguls, Germany needs to cut at least 10 billion EUR from its spending every year until 2016. That’s six years of job cuts, restricted spending, lower wages, and higher taxes. Ouch!

Just around the corner, UK looks ready to join the bandwagon. They may have dodged a downgrade and got off on a warning from credit rating agency Fitch, but there’s no denying that the UK needs to take drastic steps to trim its budget deficit. With their economic footing still shaky, austerity measures could cause more damage in the UK.

Spending only what you earn is easier said than done. All these austerity measures do not come without a cost.

Since government spending accounts for a significant chunk of a country’s GDP, austerity measures have this nasty effect of holding back growth. With central banks all over the globe adopting expansionary policies because of the most recent financial crisis, the implementation of austerity measures is counter-productive.

Welfare also takes a hit. Austerity measures typically require a restructuring, i.e. a decline in social security, pension payments, and health services, which causes the overall standard of living to fall. In effect, everybody works more for fewer benefits.

Fiscal austerity may be the solution to debt problems, but it runs contrary to the expansionary policies of central banks. I guess we just have to face the truth and brace ourselves for hard times ahead. Hopefully, by the end of it all, we would have learned from our mistakes!