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On Austerity Impact and the Debt Deflation Process
by Panayotis Economopoulos
A fiscal consolidation program that reduces spending and raises taxes has 2 stage effects.
1. A the first stage, its impact is to bring a substantial disposalbe income reduction and an effective demand and total economic activity shortfall and this effect is well analyzed.
2. At the second stage, its impact is to bring a debt deflation process that can result in a contractionary feedback loop with an economic and financial crisis.
a. The spending cuts reduces disposable income and the ability of private economic units to repay their debt and tax obligations.
b. The rise in tax rates increases the tax obligations that become overdue leading to sale and confiscation of assets causing a drop of asset prices.
c. Price deflation from effective demand and total economic activity shortfall raises the value of debt and tax obligations.
d. Disposalbe income reduction causes debt obligations to become overdue leading to sale of assets and a drop of asset prices.
e. The drop of asset prices and the rising value of debt and tax obligations cause wealth value of private portfolios to contract significantly turning private units to insolvency.
f. The combination of these effects raises the value of non-performing debt and financial institutions suffer a drop in capital adequacy causing them to reduce credit extension while their credit rating with the central bank and interbank money markets is downgraded causing them face a liquidity crunch.
g. The result of all these effects is to force abank bail out by the fiscal authority, otherwise banks willfail and cause a bank panic.
h. The state fiscal authority whose austerity measures initiated the process ends with a rising public debt as a percent of GDP that becomes unsustainable for financial markets.
The outcome of all these relations, induces by the initial fiscal consolidation program, is to initiate a series of negative feedback effects, a spiral that leads to an economic implosion and financial crisis!