What Is Austerity?

The term austerity refers to a set of economic policies that a government implements in order to control public sector debt. Governments put austerity measures in place when their public debt is so large that the risk of default or the inability to service the required payments on its obligations becomes a real possibility.

In short, austerity helps bring financial health back to governments. Default risk can spiral out of control quickly and, as an individual, company, or country slips further into debt, lenders will charge a higher rate of return for future loans, making it more difficult for the borrower to raise capital.

How Austerity Works

Governments experience financial instability when their debt outweighs the amount of revenue they receive, resulting in large budget deficits. Debt levels generally increase when government spending increases. As mentioned above, this means that there is a greater chance that federal governments can default on their debts. Creditors, in turn, demand higher interest to avoid the risk of default on these debts. In order to satisfy their creditors and control their debt levels, they may have to take certain measures.

Austerity only takes place when this gap—between government receipts and government expenditures—shrinks. This situation occurs when governments spend too much or when they take on too much debt. As such, a government may need to consider austerity measures when it owes more money to its creditors than it receives in revenues. Implementing these measures helps put confidence back into the economy while helping restore some semblance of balance to government budgets.

Austerity measures indicate that governments are willing to take steps to bring some degree of financial health back to their budgets. As a result, creditors may be willing to lower interest rates on debt when austerity measures are in place. But there may be certain conditions on these moves.

For instance, interest rates on Greek debt fell following its first bailout. However, the gains were limited to the government having decreased interest rate expenses. Although the private sector was unable to benefit, the major beneficiaries of lower rates are large corporations. Consumers benefited only marginally from lower rates, but the lack of sustainable economic growth kept borrowing at depressed levels despite the lower rates.

Special Considerations

A reduction in government spending doesn’t simply equate to austerity. In fact, governments may need to implement these measures during certain cycles of the economy.

For example, the global economic downturn that began in 2008 left many governments with reduced tax revenues and exposed what some believed were unsustainable spending levels. Several European countries, including the United Kingdom, Greece, and Spain, turned to austerity as a way to alleviate budget concerns.

Austerity became almost imperative during the global recession in Europe, where eurozone members didn’t have the ability to address mounting debts by printing their own currency. Thus, as their default risk increased, creditors put pressure on certain European countries to aggressively tackle spending.

Types of Austerity

Broadly speaking, there are three primary types of austerity measures:

• Generating revenue generation through higher taxes. This method often supports more government spending. The goal is to stimulate growth with spending and capturing benefits through taxation.
• The Angela Merkel model. Named after the German chancellor, this measure focuses on raising taxes while cutting nonessential government functions.
• Lower taxes and lower government spending. This is the preferred method of free-market advocates.

Taxes

There is some disagreement among economists about the effect of tax policy on the government budget. Former Ronald Reagan adviser Arthur Laffer famously argued that strategically cutting taxes would spur economic activity, paradoxically leading to more revenue.

Still, most economists and policy analysts agree that raising taxes will raise revenues. This was the tactic that many European countries took. For example, Greece increased value-added tax (VAT) rates to 23% in 2010. The government raised income tax rates on upper-income scales, along with adding new property taxes.

Reducing Government Spending

The opposite austerity measure is reducing government spending. Most consider this to be a more efficient means of reducing the deficit. New taxes mean new revenue for politicians, who are inclined to spend it on constituents.

Spending takes many forms, including grants, subsidies, wealth redistribution, entitlement programs, paying for government services, providing for the national defense, benefits to government employees, and foreign aid. Any reduction in spending is a de facto austerity measure.

At its simplest, an austerity program that is usually enacted by legislation may include one or more of the following measures:

• A cut or a freeze—without raises—of government salaries and benefits
• A freeze on government hiring and layoffs of government workers
• A reduction or elimination of government services, temporarily or permanently
• Government pension cuts and pension reform
• Interest on newly issued government securities may be cut, making these investments less attractive to investors, but reducing government interest obligations
• Cuts to previously planned government spending programs such as infrastructure construction and repair, health care, and veterans’ benefits
• An increase in taxes, including income, corporate, property, sales, and capital gains taxes
• A reduction or increase in the money supply and interest rates by the Federal Reserve as circumstances dictate to resolve the crisis.
• Rationing of critical commodities, travel restrictions, price freezes, and other economic controls, particularly in times of war

Criticism of Austerity

The effectiveness of austerity remains a matter of sharp debate. While supporters argue that massive deficits can suffocate the broader economy, thereby limiting tax revenue, opponents believe that government programs are the only way to make up for reduced personal consumption during a recession. Cutting government spending, many believe, leads to large-scale unemployment. Robust public sector spending, they suggest, reduces unemployment and therefore increases the number of income-tax payers. 

Economists such as John Maynard Keynes, a British thinker who fathered the school of Keynesian economics, believe that it is the role of governments to increase spending during a recession to replace falling private demand. The logic is that if demand is not propped up and stabilized by the government, unemployment will continue to rise and the economic recession will be prolonged.

But austerity runs contradictory to certain schools of economic thought that have been prominent since the Great Depression. In an economic downturn, falling private income reduces the amount of tax revenue that a government generates. Likewise, government coffers fill up with tax revenue during an economic boom. The irony is that public expenditures, such as unemployment benefits, are needed more during a recession than a boom.

Examples of Austerity

United States

Perhaps the most successful model of austerity, at least in response to a recession, occurred in the United States between 1920 and 1921. The unemployment rate in the U.S. economy jumped from 4% to almost 12%. Real gross national product (GNP) declined almost 20%—greater than any single year during the Great Depression or Great Recession.

President Warren G. Harding responded by cutting the federal budget by almost 50%. Tax rates were reduced for all income groups, and the debt dropped by more than 30%. In a speech in 1920, Harding declared that his administration “will attempt intelligent and courageous deflation, and strike at government borrowing…[and] will attack high cost of government with every energy and facility.”

Greece

In exchange for bailouts, the EU and European Central Bank (ECB) embarked on an austerity program that sought to bring Greece’s finances under control. The program cut public spending and increased taxes often at the expense of Greece’s public workers and was very unpopular. Greece’s deficit has dramatically decreased, but the country’s austerity program has been a disaster in terms of healing the economy.

Mainly, austerity measures have failed to improve the financial situation in Greece because the country is struggling with a lack of aggregate demand. It is inevitable that aggregate demand declines with austerity. Structurally, Greece is a country of small businesses rather than large corporations, so it benefits less from the principles of austerity, such as lower interest rates. These small companies do not benefit from a weakened currency, as they are unable to become exporters.

While most of the world followed the financial crisis in 2008 with years of lackluster growth and rising asset prices, Greece has been mired in its own depression. Greece’s gross domestic product (GDP) in 2010 was $299.36 billion. In 2014, its GDP was $235.57 billion according to the United Nations. This is staggering destruction in the country’s economic fortunes, akin to the Great Depression in the United States in the 1930s.

Greece’s problems began following the Great Recession, as the country was spending too much money relative to tax collection. As the country’s finances spiraled out of control and interest rates on sovereign debt exploded higher, the country was forced to seek bailouts or default on its debt. Default carried the risk of a full-blown financial crisis with a complete collapse of the banking system. It would also be likely to lead to an exit from the euro and the European Union.

What Is an Available-for-Sale Security?

An available-for-sale security (AFS) is a debt or equity security purchased with the intent of selling before it reaches maturity or holding it for a long period should it not have a maturity date. Accounting standards necessitate that companies classify any investments in debt or equity securities when they are purchased as held-to-maturity, held-for-trading, or available-for-sale. Available-for-sale securities are reported at fair value; changes in value between accounting periods are included in accumulated other comprehensive income in the equity section of the balance sheet.

How an Available-for-Sale Security Works

Available-for-sale (AFS) is an accounting term used to describe and classify financial assets. It is a debt or equity security not classified as a held-for-trading or held-to-maturity security—the two other kinds of financial assets. AFS securities are nonstrategic and can usually have a ready market price available.

The gains and losses derived from an AFS security are not reflected in net income (unlike those from trading investments), but show up in the other comprehensive income (OCI) classification until they are sold. Net income is reported on the income statement. Therefore, unrealized gains and losses on AFS securities are not reflected on the income statement.

Net income is accumulated over multiple accounting periods into retained earnings on the balance sheet. In contrast, OCI, which includes unrealized gains and losses from AFS securities, is rolled into “accumulated other comprehensive income” on the balance sheet at the end of the accounting period. Accumulated other comprehensive income is reported just below retained earnings in the equity section of the balance sheet.

Available-for-Sale vs. Held-for-Trading vs. Held-to-Maturity Securities

As mentioned above, there are three classifications of securities—available-for-sale, held-for-trading, and held-to-maturity securities. Held-for-trading securities are purchased and held primarily for sale in the short term. The purpose is to make a profit from the quick trade rather than the long-term investment. On the other end of the spectrum are held-to-maturity securities. These are debt instruments or equities that a firm plans on holding until its maturity date. An example would be a certificate of deposit (CD) with a set maturity date. Available for sale, or AFS, is the catch-all category that falls in the middle. It is inclusive of securities, both debt and equity, that the company plans on holding for a while but could also be sold.

From an accounting perspective, each of these categories is treated differently and affects whether gains or losses appear on the balance sheet or income statement. The accounting for AFS securities is similar to the accounting for trading securities. Due to the short-term nature of the investments, they are recorded at fair value. However, for trading securities, the unrealized gains or losses to the fair market value are recorded in operating income and appear on the income statement. 

Changes in the value of available-for-sale securities are recorded as an unrealized gain or loss in other comprehensive income (OCI). Some companies include OCI information below the income statement, while others provide a separate schedule detailing what is included in total comprehensive income.

Recording an Available-for-Sale Security 

If a company purchases available-for-sale securities with cash for $100,000, it records a credit to cash and a debit to available-for-sale securities for $100,000. If the value of the securities declines to $50,000 by the next reporting period, the investment must be “written down” to reflect the change in the fair market value of the security. This decrease in value is recorded as a credit of $50,000 to the available-for-sale security and a debit to other comprehensive income.

Likewise, if the investment goes up in value the next month, it is recorded as an increase in other comprehensive income. The security does not need to be sold for the change in value to be recognized in OCI. It is for this reason these gains and losses are considered “unrealized” until the securities are sold.

What Is an Annuity Table?

An annuity table is a tool for determining the present value of an annuity or other structured series of payments. Such a tool, used by accountants, actuaries, and other insurance personnel, takes into account how much money has been placed into an annuity and how long it has been there to determine how much money would be due to an annuity buyer or annuitant.

Figuring the present value of any future amount of an annuity may also be performed using a financial calculator or software built for such a purpose.

How an Annuity Table Works

An annuity table provides a factor, based on time, and a discount rate (interest rate) by which an annuity payment can be multiplied to determine its present value. For example, an annuity table could be used to calculate the present value of an annuity that paid $10,000 a year for 15 years if the interest rate is expected to be 3%.

According to the concept of the time value of money, receiving a lump sum payment in the present is worth more than receiving the same sum in the future. As such, having $10,000 today is better than being given $1,000 per year for the next 10 years because the sum could be invested and earn interest over that decade. At the end of the 10-year period, the $10,000 lump sum would be worth more than the sum of the annual payments, even if invested at the same interest rate.

Annuity Table and the Present Value of an Annuity

Present Value of an Annuity Formulas

The formula for the present value of an ordinary annuity, as opposed to an annuity due, is as follows:


$\begin{aligned}&\text{P} =\text{PMT}\times\frac{ 1 – (1 + r) ^ -n}{r}\\&\textbf{where:}\\&\text{P} = \text{Present value of an annuity stream}\\&\text{PMT} =\text{Dollar amount of each annuity payment}\\&r = \text{Interest rate (also known as the discount rate)}\\&n = \text{Number of periods in which payments will be made}\end{aligned}$​P=PMT×r1−(1+r)−n​where:P=Present value of an annuity streamPMT=Dollar amount of each annuity paymentr=Interest rate (also known as the discount rate)​

Assume an individual has an opportunity to receive an annuity that pays $50,000 per year for the next 25 years, with a discount rate of 6%, or a lump sum payment of $650,000. He needs to determine the more rational option. Using the above formula, the present value of this annuity is:


$\begin{aligned}&\text{PVA} = \$50,000 \times \frac{1 – (1 + 0.06) ^ -25}{0.06} = \$639,168\\&\textbf{where:}\\&\text{PVA}=\text{Present value of annuity}\end{aligned}$​PVA=$50,000×0.061−(1+0.06)−25​=$639,168where:​

Given this information, the annuity is worth $10,832 less on a time-adjusted basis, and the individual should choose the lump sum payment over the annuity.

Note, this formula is for an ordinary annuity where payments are made at the end of the period in question. In the above example, each $50,000 payment would occur at the end of the year, each year, for 25 years. With an annuity due, the payments are made at the beginning of the period in question. To find the value of an annuity due, simply multiply the above formula by a factor of (1 + r):


$\begin{aligned}&\text{P} = \text{PMT} \times\left(\frac{1 – (1 + r) ^ -n}{r}\right) \times (1 + r)\end{aligned}$​P=PMT×(r1−(1+r)−n​)×(1+r)​

If the above example of an annuity due, its value would be:


$\begin{aligned}&\text{P}= \$50,000\\&\quad \times\left( \frac{1 – (1 + 0.06) ^ -25}{0.06}\right)\times (1 + 0.06) = \$677,518\end{aligned}$​P=$50,000​

In this case, the individual should choose the annuity due, because it is worth $27,518 more than the lump sum payment.

Present Value of an Annuity Table

Rather than working through the formulas above, you could alternatively use an annuity table. An annuity table simplifies the math by automatically giving you a factor for the second half of the formula above. For example, the present value of an ordinary annuity table would give you one number (referred to as a factor) that is pre-calculated for the (1 – (1 + r) ^ – n) / r) portion of the formula.

The factor is determined by the interest rate (r in the formula) and the number of periods in which payments will be made (n in the formula). In an annuity table, the number of periods is commonly depicted down the left column. The interest rate is commonly depicted across the top row. Simply select the correct interest rate and number of periods to find your factor in the intersecting cell. That factor is then multiplied by the dollar amount of the annuity payment to arrive at the present value of the ordinary annuity.

Below is an example of a present value of an ordinary annuity table: