Austerity Measures: Do they avert solvency crises? 

Full Name: Christos Shiamptanis

Academic Affiliation: Wilfrid Laurier University

Position: Assistant Professor


Abstract: The recent solvency crisis in Europe highlighted the importance of austerity, whereby governments must aggressively raise taxes. Highly indebted countries adopted or are currently adopting austerity measures to rein in their elevated debt levels with the hope to allay the possibility of future solvency crisis. In Greece after six years of strict austerity measures, there are no signs that the government can escape the crisis and re-attain a solvent position in the near future. In contrast, Italy is easing up on austerity, despite its ever-growing debt. In this paper, we investigate the implications of austerity on solvency crisis. Does austerity avert the likelihood of future insolvency? Or does it prolong an existing crisis? Could a country improve its current fiscal position as it eases up on austerity?

This paper explores the implications of austerity on the maximum level of debt consistent with solvency, defined as the effective fiscal limit. We find that the position of the effective fiscal limit depends on austerity. We find that a country that implements strict austerity could become insolvent. And equivalently, a country that eases austerity could regain access to the markets and re-attain a solvent position. Our model warns of future solvency crisis, should countries undergo strict austerity in the near future.