Does austerity pay off?

Benjamin Born, Gernot Müller, Johannes Pfeifer 22 February 2015



Ever since their emergence in the wake of the financial crises, austerity policies have been hotly debated (see, for example, Corsetti 2012). The recent electoral outcome in Greece is just one instance where discontent with austerity manifests itself. Many observers and voters are ready to jump from jointly observing poor economic outcomes and austerity to the conclusion that austerity is indeed the cause (see, for instance, Blyth 2013). Others have provided sophisticated analyses in support of the same view (see Taylor 2013).

One might think that instead, financial markets should entertain more sympathetic views of austerity; after all, austerity is often meant to placate investors. Still, in many European crisis countries yield spreads kept rising during times of austerity, at least until mid-2012. Some observers have thus suggested that financial markets are indeed ‘schizophrenic’ about austerity (Blanchard 2011). In a new study, we investigate the issue systematically (Born et al. 2015). We ask whether cuts of government consumption cause the sovereign default premium to fall and, thus, whether austerity pays off in terms of reduced borrowing costs.

Does austerity payoff? New evidence

Our analysis is based on a new data set which covers 38 emerging and advanced economies from 1990 to 2014. It contains quarterly observations for government consumption, output, and the sovereign default premium measured on the basis of yield spreads of common-currency bonds. In order to assess how government consumption impacts the default premium and other variables of interest, we assume that government consumption is predetermined within a given quarter because of decision lags. A close reading of documents which detail austerity policies during the recent crisis suggests that this holds true even in times of severe fiscal stress. We order our results along two dimensions.

  • First, we distinguish a scenario of fiscal stress, that is, when the sovereign default premium is initially high, and a scenario of more benign times (low premium).
  • Second, we differentiate between short-run and long-run effects.

Figure 1. Dynamic response to an exogenous cut of government consumption by 1% of GDP.

Notes: Upper row: short-run dynamics; bottom row: long-run dynamics. Horizontal axis measures time in quarters, shaded areas and dotted lines indicate 90% confidence bounds.

Figure 1 displays how a cut of government consumption by one percent of GDP impacts the economy over time. Horizontal axes measure time in quarters. The top row pertains to the short run (the first two years after the initial cut). Red dashed lines capture the dynamics in case the economy suffers from fiscal stress, blue solid lines instead pertain to the case of benign times. The left panel shows the response of government consumption. The cut of public consumption is temporary and not significantly different across initial conditions (stress/no stress). The middle panel shows the response of output. It differs strongly across initial conditions. In times of fiscal stress, cutting government consumption by 1% of GDP reduces GDP temporarily by about 1%. In contrast, in the absence of fiscal stress there is no significant output effect. Finally, the right panel shows the response of the sovereign default premium. Again, initial conditions matter. In times of fiscal stress, the premium rises (!) in response to austerity by up to 40 basis points; it falls (mildly) in benign times.

The bottom row shows results for the long run (up to 12 years after the initial cut). We find that a (temporary) cut of government consumption lowers the default premium. The effect is hardly significant if times are benign (blue solid lines), but rather strong in times of fiscal stress. A cut of government consumption reduces the premium by about 50 basis points in the long run. As before, we observe a spike in the premium in the immediate aftermath of the initial cut. But now we can also see that the premium declines below its initial level after 2 years; 5 years after the initial cut the premium has fallen by 40 basis points relative to the initial level.

A noteworthy result of our analysis is that the premium co-moves strongly with output. This holds true both unconditionally (the correlation of premium and output growth is negative in all 38 countries of our sample) and conditional on spending cuts, notably in the short run.

Also, as Figure 1 illustrates, the default premium starts to decline when output rebounds. This confirms the view that financial markets are primarily concerned with the growth effects of austerity (Cotarelli 2012).

We interpret our findings through the lens of a structural model of optimal sovereign default. Specifically, we modify the model of Arellano (2008) by allowing for exogenous variation in government consumption and a multiplier effect of such variation on output. On the basis of model simulations we find that cutting government consumption may indeed raise the default premium in the short run. This is not because investors are impatient or schizophrenic about austerity. Rather, this is because with output being temporarily reduced due to austerity, financial market participants understand that a government is tempted to default on its debt obligations in order to free scarce resources from debt service for other expenditures.

Concluding remarks

Our results have important implications for policy.

  • First, whether austerity is painful in the short run depends on the level of fiscal stress.

As spending cuts cause little harm under benign initial conditions, it is advisable to prevent fiscal stress from building up in the first place. Admittedly, more often than not policymakers will have missed this opportunity. As a result, austerity is likely to be painful in the short run and the temptation to renege on debt obligations increases. Because market participants understand this, they demand a higher default premium. A naïve observer may therefore conclude that austerity “is not working”. In this regard, however, our analysis offers a second important insight:

  • If policymakers and the electorate show sufficient resolve, carrying through with austerity will eventually be rewarded by better financing conditions. Austerity pays off in the long run.


Blyth, M. (2013), Austerity: The History of a Dangerous Idea, Oxford, UK: Oxford University Press.

Born, B, G Müller and J Pfeifer (2015), “Does austerity pay off?”, CEPR Discussion paper.

Blanchard, O (2011), “2011 in review: four hard truths”, IMFdirect blog, 21 December.

Corsetti, G (2012), “Has austerity gone too far? A new Vox Debate”,, 2 April.

Cottarelli, C (2012), “The austerity debate: Festina Lente!”,, 20 April.

Taylor, A (2013), “When is the time for austerity?”,, 20 July.



Topics:  Financial markets Macroeconomic policy

Tags:  austerity policies, government spending

Assistant Professor in the Department of Economics, University of Mannheim; and CEPR Research Affiliate

Professor of Economics, University of Tübingen

Assistant Professor at the Department of Economics, University of Mannheim

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