Question

(Related to Solved Problem 27.6 on page 971 ) A 2015 article in the Wall Street Journal noted that an official of the European Union was forecasting that "Greece faces two years of recession amid sharp budget cuts." What typically happens to a government's budget deficit during a recession? Do governments typically respond with budget cuts as the Greek government did? Briefly explain.

Short answer

During a recession, the government's budget deficit typically increases due to a decrease in tax revenue and potentially increased government expenditure. Most governments respond with fiscal stimulus, either increasing spending or decreasing taxes to stimulate the economy. However, the Greek government responded with budget cuts, common referred to as 'austerity measures', contrary to the typical response.

Step-by-step solution

Understand Recession and Budget Deficit Association

In a time of recession, tax revenue usually goes down due to decrease in corporate profits and personal income. As the unemployment rate rises, government expenditure on unemployment benefits can also increase. Thus, the deficit in the government's budget (the difference between its revenue and expenditure) typically increases.

Identify the Typical Governmental Response to Recession

Typically, during a recession, governments often employ 'counter-cyclical' fiscal policies. They either increase their spending (fiscal stimulus) or decrease taxes to stimulate the economy. An increase in government spending, or a decrease in tax rates, can stimulate demand and potentially help pull the economy out of recession.

Compare Typical Response with Greek Government's Response

In contrast to this typical response, the Greek government implemented budget cuts during their recession. This is commonly known as 'austerity measures'. The Greek government cut its expenditure in order to reduce the budget deficit, possibly due to obligations to its creditors, rather than using a fiscal stimulus which is the more typical response.

Key concepts

Fiscal Policy

When discussing economic stability and growth, fiscal policy is one of the most crucial tools at a government's disposal. Fiscal policy involves adjustments in government spending and taxation to influence economic activity. During an economic downturn or recession, a government's revenue often decreases because companies and individuals earn less, leading to lower tax income. Simultaneously, certain expenditures, particularly social safety nets like unemployment benefits, often increase because more people require support.

Traditionally, a government might respond to a recession by implementing expansionary fiscal policy. This involves increasing government expenditures or decreasing taxes to stimulate economic activity. By doing so, the government can increase demand in the economy, leading to higher production and employment levels. This is the essence of using fiscal policy as a tool to fight recessionary pressures, essentially aiming to buffer the negative impacts of an economic downturn on individuals and businesses.

Understanding this concept is vital as it frames how a government can actively seek to manage economic challenges, rather than merely reacting to them. By tailoring fiscal policies that align with the economic cycle, a government can mitigate the effects of a recession and pave the road to recovery.

Counter-Cyclical Measures

Counter-cyclical measures are economic policies or actions taken by governments or financial authorities to counteract the negative effects of economic fluctuations. These measures are designed to move in the opposite direction of the current economic trend—stimulating the economy during periods of recession and slowing it down during times of rapid expansion.

Applying counter-cyclical measures during recessions involves increasing government spending, reducing taxes, or both. By injecting more money into the economy, either through direct government investment in infrastructure, services, or by leaving more money in consumers' pockets through tax cuts, the demand for goods and services can be bolstered. This increased demand can help stimulate production and encourage employment, gradually leading to economic recovery.

It is crucial to realize that these measures are often planned to be temporary. Once the economy starts recovering, a government would typically look to roll back expansionary policies through a process known as fiscal consolidation, to avoid overheating the economy and contributing to inflation.

Austerity Measures

In contrast to the expansionary counter-cyclical measures, austerity measures involve tightening the fiscal policy. This approach usually includes decreasing government spending, increasing taxes, or a combination of both, with the aim to reduce government budget deficits and stabilize public finances.

Austerity is often controversial, especially during recessions. While it can be beneficial in the long term by reducing government debt and potentially improving the credibility of government finances, it might also lead to a deeper recession in the short term. This happens because reducing government spending and increasing taxes can decrease overall demand in the economy. In the case of Greece, austerity was largely influenced by external pressures from creditors and the need to comply with fiscal targets set by international financial institutions.

Understanding austerity is important as it highlights the delicate balance governments must maintain between promoting economic growth and ensuring sustainable fiscal conditions. Occasionally, as a result of international negotiations or severe debt levels, a government's typical response to a recession may be constrained, requiring austerity despite its potential to exacerbate the economic slowdown.