Austerity is a topic that has generated significant visibility over the last several years as many countries used it to shore up their fiscal situation following the financial crisis. While definitions varying slightly, there are some common themes.

The Financial Times provides the following explanation:

"Austerity measures refer to official actions taken by the government, during a period of adverse economic conditions, to reduce its budget deficit using a combination of spending cuts or tax rises. Various austerity measures have been announced since the global recession in 2008 and the eurozone crisis in 2009."[1]

The Economist sheds further light on the subject, emphasizing that austerity measures aim to reduce the structural deficit, which is the difference between tax revenue and government spending that is created regardless of where the economy is in the business cycle.[2]

It is also worth noting that when a government cuts spending and or increases taxes, doing so may not balance the budget. In some cases, a nation's deficit may represent a high percentage of gross domestic product even after implementing austerity measures.

Why Is Austerity Needed?

Nations use austerity measures to get their budget deficits under control. Otherwise, these shortfalls will keep adding up, pushing the national debt higher. As this debt increases, paying interest on this obligation will require a steadily increasing budget expenditure. In addition, rising government debt can place upward pressure on the yields of government bonds.[3] The higher these yields go, the more a country will need to pay every time it wants to borrow money. In addition, rising yields could hinder private investment.

If a nation faces ever-mounting debt, this development could make investors nervous and prevent them from buying the country's currency. In this instance, users of that native currency will need to pay more to buy foreign goods and services.

Why Do We Need Austerity Now?

After the financial crisis, a large number of nations operated with a substantial budget deficit.[4] The widespread incidence of these fiscal challenges created great concern, as many worried that any country running a sizable deficit was at risk of becoming like Greece.

Amid this perceived threat, many economists pointed to austerity measures as a promising remedy. While opponents argued these tactics would make matters worse for economies suffering challenges, advocates contended that having this kind of fiscal discipline would help bolster confidence. In 2010, nations across the world turned to austerity measures.

Why Should Investors Care?

Forex investors should be familiar with austerity, as well as its implications, for several reasons. First of all, any increases in taxes or reductions in government spending can have a major impact on a nation's economy. Also, as many economists have argued, austerity measures can easily affect the confidence of global market participants.[4] More specifically, these proponents have contended that if a country can trim its deficit, this fiscal responsibility can help bolster confidence, providing the economy with tailwinds.

Both the effect on economic conditions and the impact on investor confidence can play a key role in whether market participants flock to or shun a particular currency.

The Benefits of Austerity

Implementing austerity measures can benefit a country, and also its currency, in several ways. The merits of austerity are even more striking during a debt crisis, as a nation can help push interest rates lower by getting its fiscal house in order and alleviating concerns it will default on its debt.[5]

Reducing interest rates generally helps support economic growth. More specifically, it facilitates both investment and consumption in sectors that respond to significant changes in these borrowing costs. In addition, keeping budget deficits modest can help create the perception of stability, which in turn can produce foreign direct investment.

If global market participants believe a nation is stable, they will be more likely to buy its assets, which will probably help place upward pressure on the country's native currency.

The Costs of Austerity

While imposing austerity measures may produce numerous benefits, it can also generate costs. If a country raises taxes, doing so will put less money in people's pockets, placing downward pressure on both consumption and investment. The same result will likely come from cutting government expenditures.

In both of these instances, austerity measures could reduce a nation's growth and undermine its labor market. Spain, Portugal and Greece all implemented harsh austerity measures between 2009 and 2013, the final year of substantial budget cuts, and suffered economic contraction during that time.[4]

Government expenditures are a key component of GDP. When a nation opts to cut spending, doing so will increase its debt-to-GDP ratio, all things being equal.[5]

When this ratio is modest, it is a sign that a country has the ability to sell enough goods and services to pay off current debt without borrowing more money. However, if this ratio gets too high, investors may grow concerned about the nation's fiscal solvency, fleeing its assets and placing downward pressure on its native currency.

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