As many European nations struggled to recover from the COVID crisis and the economic effects of the war in Ukraine, austerity emerged as a controversial yet necessary approach to addressing deep economic vulnerabilities. With ballooning deficits, mounting debt burdens, and investor confidence shaken, austerity measures aimed to restore fiscal discipline and stability. Detractors argue that government spending cuts only depress demand and inhibit growth in the short run. However, proponents contend that the fiscal recklessness that precipitated the crisis necessitated austerity's short-term pain for long-term gain. Implemented properly, austerity can reduce unsustainable deficits, instill market confidence, spur competitiveness, and ultimately cultivate an environment conducive to investment and sustainable expansion. Though requiring difficult sacrifices, austerity provides troubled economies with a viable path toward corrected imbalances and prosperity. The recent European debt crisis underscores the potential effectiveness of prudent austerity measures.

In economic terms, austerity refers to the economic measures that governments impose to control public sector debt. These measures are put in place when the size of public debt is so big that the risk of the government defaulting on their debts is large. With evergrowing budget deficits among the EU members and less liquidity in the system, interest rates will continue to grow and creditors are going to demand a higher rate of return in exchange for the higher risk that they’re taking.

There are three types of austerity:

One of the biggest modern-day examples of austerity working is the Nordic nations (Denmark, Finland, Sweden, and Norway). While we see these nations continue to be the envy of Europe, the historical context shows that these nations show that the success they have today didn’t come without hard decisions. In the early 1990s, the four Nordic nations nearly went bankrupt and had to undergo strong austerity measures to save themselves. At least during those times, the rest of the world was growing at a healthy pace.

One of the main reasons why the Nordic states endured a sovereign debt crisis was because, during the 1970s, left-wing policymakers ruled those nations and focused on increasing the size of the public sector, tax rates, and regulations. The 1990s were a time when the Nordic nations saw the limits of big government and where the people knew that a new economic model needed to be adopted. After undergoing austerity measures, the Nordic nations imposed rules to restrain the growth of the public sector and maximize the productivity that the nation can get from their tax dollars.

All nations encounter times of crisis. The thing that makes a nation wealthier in the long run after a crisis and another crisis worse off in the long run is how they approach the crisis. While all nations will impose short-term crisis management measures, nations that become wealthier in the long run, like the Nordic nations, added long-term entitlement reform as well. Many European nations would not conduct long-term entitlement reform in a sovereign debt crisis and because of that, they perform sluggishly after the crisis.

While European policymakers like to impose many regulations on businesses, the Nordic nations prefer to make it easier for businesses to operate in their country. Through lowering taxes and regulations along with cultivating an entrepreneurial culture, many successful companies are being built in those nations. Skype and Spotify were founded in Sweden. Two of the most popular mobile app developers, Supercell (maker of Clash of Clans) and Rovio (maker of Angry Birds) were founded in Finland.

Without a government that promotes long-term growth, the gains from austerity measures will be limited. Sure, investors would be willing to require a lower rate of return for sovereign debt, but without economic growth, those nations would look less appealing to investors.

For the non-Nordic European nations that are struggling with widening deficit spending and large levels of debt, austerity looks to be the only way to a better tomorrow. France is looking to enter a period of unprecedented austerity. Germany’s finance minister is drafting an austerity package for the nation, which is deindustrializing at an unprecedented pace due to the energy crisis caused by the Russian invasion of Ukraine. The UK imposed a new era of austerity measures to boost investor confidence. The pains from austerity will be temporary, but the gains from it will be immense. I’m confident that European policymakers will add policies that promote long-term growth along with short-term crisis management. Europe’s future remains exciting as it’s likely that they could adopt the Nordic model.

Investors of European equities and debt, who hold a long-term view, should support austerity measures throughout the continent. Lowering taxes and lowering government spending simultaneously is the ideal austerity approach. Without it, it’s hard to envision Europe getting out of its economic stagnation.

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