This week has seen yet another eurozone economy on the brink of default and serious financial collapse. Eyes around the world have turned to Cyprus, the small island nation just south of Turkey. The country just secured a deal with the European Union (EU) to receive 10 billion euros as an emergency loan to keep the country’s banks from defaulting. Cyprus is just one of multiple eurozone economies who have required large bailouts from the EU and the International Monetary Fund(IMF) just to stay solvent. Along with these bailouts have come stringent austerity measures that cut spending to the bare bones in order to reign in government costs. But that strategy is doing more to hurt the fragile economies than it is to help.
Basic economics tells us that you shouldn’t spend more money than you take in. And that has been the problem with multiple eurozone economies like Greece, whose debt has risen to an estimated 188 percent of its GDP this year, despite multiple EU bailouts. But research shows that some of the strict austerity measures demanded by the EU have actually accelerated the rise in debt. While spending cuts are important, they have to be balanced and evenhanded.
The IMF released the Global World Outlook near the end of 2012, and in that report, the organization’s chief of economics concluded that serious austerity measures have had a more detrimental effect than economists predicted. The problem lies within the fiscal multiplier, which measures the effects of changed spending habits on an economy. In cases of serious austerity measures, economists have undervalued the fiscal multiplier, which means the spending cuts, in reality, do more damage than expected. That was, and still is, likely a contributing factor in the Greek economy’s worsening free fall. The Greek government has long had a problem collecting sufficient revenue through taxation, so tax increases were clearly in order. But Greece also proposed 28 billion euros in spending cuts, and that is where its government went wrong. Greece may have needed to cut spending some, but a cut of this magnitude, in conjunction with tax increases, was enough to stunt the growth of the economy.
Cyprus will not likely have to face any austerity measures because their crisis is mostly restricted to banks, which suffered heavy losses from their investments in Greece. But it is inevitable that another eurozone economy will need saving again, and it is imperative that the European Union handles it in a way that will produce growth instead of hamstringing a nation’s economy for years, as with Greece. Every case is different, but it is clear that spending cuts with tax increases kill growth, and the sooner the EU figures that out the better.