The West's horrible fiscal choice
The US, Britain, and Europe are together embarking on a sudden and severe tightening of fiscal policy, in unison, before economic recovery has reached safe take-off speed. The experiment was last tried in the 1930s.
Published 04/08/2011 | 08:27
The theoretical model behind the austerity push – known as an "expansionary fiscal contraction" – is based on the work of German theorists, and more recently on studies by Harvard professor Alberto Alesina and a group of brave scholars willing to defy the canonical doctrine of post-war Keynesian economics.
The Alesina view has been embraced by the European Central Bank and the budget cutters of the Eurogroup, but has enraged America's professoriat and set off a heated argument across the world.
Former US Treasury Secretary Larry Summers said there is now a one-third chance of a full-blown recession next year in the US. Nobel leaureate Paul Krugman said obscurantists had run amok. "What we're witnessing here is a catastrophe on multiple levels. We are doing a terrible thing. We are repeating all the mistakes of the 1930s, doing our best shot at recreating the Great Depression," he said.
Fear that a synchronized squeeze in half the global economy may go horribly wrong has seeped into market psychology, explaining why the $2.4 trillion (£1.5 trillion) debt deal agreed in Washington has failed to spark a relief rally. Wall Street is a step ahead, bracing for cuts in an economy that has already slipped to stall speed.
Angst over faltering recovery explains why Italian and Spanish bonds have suddenly buckled. The European Commission said the spike in Latin spreads is "clearly unwarranted" given that Rome and Madrid are sticking to their austerity plans, but this misses the point.
Investors no longer see austerity as a solution if cuts go beyond the therapeutic dose and tip Italy and Spain back into recession, playing havoc with fragile debt dynamics.
The US is expected to tighten by 2pc of GDP next year, including the expiry of payroll tax cuts and the phase-out of President Barack Obama's stimulus plan. Britain is tightening by 1.7pc this year and almost as much next year. Harsher versions are under way in Ireland and Club Med. Greece is retrenching by 16pc over three years. Canada, France and Germany will all tighten in 2012.
The International Monetary Fund said the combined effect is double the last sychronized squeeze in 1980. It comes as China is curbing credit to cool its property boom.
The Alesina school cites a string of cases where fiscal cuts led to robust recovery, and a few booms. Their work cannot be dismissed lightly and exposes the limits of New Keynesian models, which often clash with historical reality and human behaviour.
The textbook cases are: Italy (1970s); Ireland, Denmark and Sweden (1980s); Canada, Spain and the UK (1990s). There were some flops, too: Finland (1970s), Australia, Belgium and Greece (1980s), and Italy (1990s). Context is crucial. Dr Alesina says one clear message comes through from the stack of evidence: "Tax increases are much worse for the economy than spending cuts."
A study by Goran Hjelm from Sweden's Institute of Economic Research said the formula only really works when countries can let their currencies slide and export their way out of trouble. This is not possible for Spain and Italy within EMU, nor for the combined West at the same time. "We can't all devalue together and export to Mars," said Jamie Dannhauser from Lombard Street Research.
Bank of England Governor Mervyn King has called for a "grand bargain" of the world's major players to ensure that the burden of rectifying global imbalances does not fall on debtors alone, which feeds a vicious circle. "The need to act in the collective interest has yet to be recognised. Unless it is, it will be only a matter of time before one or more countries resort to protectionsism. That could, as in the 1930s, lead to a disastrous collapse in activity around the world," he said.
Fiscal contractions work best in small countries where state spending gobbles up half of GDP and where confidence has already collapsed. Getting a grip creates a huge sense of relief. Bond yields fall far enough to offet fiscal pain.
This hardly applies to the AAA bloc today: Gilt yields are trading at post-war lows of 2.73pc, while 10-year US Treasuries are 2.57pc, German Bunds are 2.4pc and Japan's JGBs are 1pc. Central banks can do little to offset budget cuts when rates are already near zero, though £200bn of quantitative easing has cushioned the blow in the UK.
Britain had its own intriguing story during the Great Depression in 1932 when it passed a draconian budget, yet recovered well. The trick was to slash rates, devalue by a quarter and retreat behind imperial tariffs. But by then the international system had already collapsed.
Of course, rich nations may not have the luxury of spending their way out of trouble any longer. The Bank for International Settlements warned last year that fiscal woes are already near "boiling point" as demographics go from bad to worse and average public debt surpasses 100pc of GDP. "Current fiscal policy is unsustainable in every country. Drastic improvements will be necessary to prevent debt ratios from exploding," it said.
The indebted West is in a frightening bind: damned if it does, and equally damned if it doesn't.