Austerity

The recent sovereign debt crisis has rekindled the debate on the role of austerity. By austerity, we mean consumption levels below those desired and supported by a country's repayment capacity. We shed light on the function, properties, and optimal size of austerity by developing a model that augments the standard sovereign debt model with incomplete information and credit rationing. We establish: First, some austerity is always inevitable. Second, intermediate levels of new loans produce less austerity than either low or high levels. And third, while the relationship between growth and austerity is ambiguous, in equilibrium the relationship is positive. Our analysis can accommodate features such as, signalling for gaining credibility, spending multipliers etc., emphasized in the austerity debates. But it suggests that they do not play a key role for understanding austerity.