Austerity is the magic word these days, and it has an interesting effect on world markets. When a country like Greece talks about austerity, it’s important to understand what this means not only for the country but for currency markets. Since forex investors want to profit from changes in currency prices, this kind of information is invaluable.
What is Austerity?
Austerity is the economic theory that states that government spending can be reduced, and taxes increased, to balance a budget. This kind of measure relies on the idea of quickly raising revenues for a government so that it can meet its most pressing liabilities while cutting unnecessary expenses and government waste. It is typical to see development projects, welfare, and other social programs cut. Increased taxes come from a hike in income taxes, port and airport fees, train and bus fare increases are also common.
By cutting government costs and increasing revenue, a government should be able to shore up its books and calm investors’ fears about bond yields. This, in turn, should help the currency markets determine how to invest.
An Example of Austerity
A few examples of austerity exist to demonstrate the real-world effects of such measures. The most recent example is Greece. The country’s first austerity package was in February of 2010. The government experienced a freeze of all government salaries, a 10 percent cut in bonuses, and overtime cuts. A second austerity package was rolled out in March of the same year. Under threats of bankruptcy, Greece passed the Economy Protection Bill. It was expected to save the country €4.8 billion. The cuts included 30 percent cuts in Christmas, Easter, and leave of absence bonuses, an additional 12 percent cut in bonuses, and a 7 percent cut in salaries of public and private employees.
The Greek government also raised its VAT from 4.5 to 5 percent, 9 to 10 percent, and from 19 to 21 percent. It also increased its tax on petrol to 15 percent and increased its existing tax on imported cars to a maximum of 30 percent. Greece went through another austerity package in May of 2010 and another in June of 2011. In 2012 it underwent more austerity measures.
The Dark Side of Austerity
For the most part, austerity has failed to balance Greece’s budget. The reason for this is simple to understand. While currency markets generally favor lower government spending and stable economies, they also favor lower regulation. Higher taxes and more regulation brings with it greater political instability. This often leads to economic instability even when the government is collecting additional revenues.
Increasing taxes often discourages workers and businesses from making more money than what is necessary to run a business or a household. Even if businesses do continue to produce, the simple fact is that tax money takes away from a business’s ability to expand and grow. Instead of reinvesting money into the company, it pays higher taxes to the government, who then uses it to pay down national debt. However, the effect of increased taxes slows economic growth and, eventually, kills tax revenues as a result.
Currency markets might be temporarily wooed by the promises of a government shoring up its books, but when the reality of political and economic stability becomes clear, markets punish the offending government by betting against its currency.
Conclusion
For all of the promises of austerity, the reality of the currency markets is telling the story of a weakening euro. If European countries cannot dig themselves out of the debt crisis soon, expect the euro to continue to weaken against every other major currency. Spain, Greece, and Italy are all threats to the eurozone and it doesn’t look like the European Central Bank has anything up its sleeve that will magically fix the situation.
Author Bio:
Guest post contributed by Stacy Pruitt, a freelance forex strategy and finance writer. Stacy writes about advanced trading and forex indicators. Click here to learn more about forex trading.
