More on how post credit bubble fiscal austerity leads to depression

In many ways, this budget-busting spending makes sense due to the huge shortfall in private sector demand as the private sector contracted and tens of millions were thrown out of work. If government had countered this contraction in the private sector with one of its own, a Great Depression was sure to come. An appreciation of the financial sector balances makes this clear. That’s what I was talking about in October of 2009 with "Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”.

But since that time, the US has resisted austerity while the UK has embraced it. In my mind, this is the best real-time economic experiment we can have on what does and doesn’t happen as a result of government spending.

On Britain’s Austerity and Rosenberg’s Depiction of Obama as Herbert Hoover, Jan 2011

Britain’s economy is a shambles as the negative impact of austerity has been made plain. Now, mind you, it was already clear from a leaked Greek bailout document that expansionary fiscal consolidation has failed in Greece. But now the OECD’s double dip warning for Britain should make this plain to all.

The OECD said in May that it expected the UK to grow by 1.8% next year, but said on Monday that it was sharply downgrading its forecast because public spending cuts, the squeeze on household incomes and a more difficult climate for exporters had weakened the economy.

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Double-dip recession: don’t say we didn’t warn you“, says the Scottish New Statesman. Now, It’s one thing to tell us that you are uncomfortable about high levels of government deficit spending and recommend fiscal consolidation despite the very negative near-term impact it will have. But, it is quite another story to invoke the mythical confidence fairy and tell us that fiscal consolidation will lead to near-term growth because of the powers of that confidence fairy. It will not and has not.

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UK Chancellor George Osborne believed in the confidence fairy. In his mind, fiscal consolidation would lead to immediate prosperity. That’s why Osborne embarked on fiscal consolidation in the first place.  Now that things have gone decidedly pear-shaped, Osborne is panicked. He is doing an about face and talking up 30 billion pounds of infrastructure stimulus. And remember, despite how the governing coalition tries to dress this one up, it is plain to all that this is a stimulus program. It won’t be nearly enough.

In the US, the situation is going to take a nasty turn as well. The super committee fiasco tells you that. As I said in July:

The cuts are coming. The President has assured as much through his misguided rhetoric. We’ll just have to see whether the economy in the US is weak enough that they cause a double dip.

Post credit bubble fiscal austerity leads to depression

And indeed I believe the US is now weak enough that these cuts will cause a double dip in the US as well.

Europe is cutting as well, not just in the periphery, but also in the core. Austria, France, Belgium, and Slovenia have added to the voices of fiscal consolidation due to the threat posed by the euro zone sovereign debt crisis. They join Portugal, Ireland, Spain, Greece and Italy as fiscal cutters. And remember, it doesn’t matter who does the cutting, private or public sector; over the short-to-medium term at least, cuts decrease consumption demand. When Europe falls into recession, the loss of tax revenue will mean budget deficits will actually increase. If the euro zone dissolves in some way, things will be considerably worse.

So, when we go into 2012, it will be much the same as it was in 2008; Europe, the UK and the US will be beset by recession and a nasty credit crisis will inflict even more damage. The difference between then and now is that the policy options are greatly diminished due to the recession and bailouts that we have already seen.

For me this speaks to downside risk and P/E compression. We are getting a nice trading bounce right now due to the news of a euro solution and Black Friday retail sales in the US. Perhaps this one can run to year’s end due to end of year tape painting. However, in 2012, when what Jeremy Grantham calls “freakishly high” profit margins begin to erode under pressure from this confluence of events in the macro picture, the lower earnings and the P/E compression will mean serious losses for those overexposed to the risk-on equity trade.

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9 Comments
  1. Anonymous says

    The figure for £30 billion of infrastructure is really only £5 billion which is savings from other departments so not really new money and £20 billion depends on pension funds being willing to invest in projects, but nothing is even agreed on that score. So yes there will be £5 billion of spending but out of a budget of £700+ billion, this will be so insignificant it is meaningless. If this fail and it will they will blame Keynesian policy again. If anyone criticises the plan they are accused of talking down the economy and scaring away the confidence fairy. 

  2. Anonymous says

    The figure for £30 billion of infrastructure is really only £5 billion which is savings from other departments so not really new money and £20 billion depends on pension funds being willing to invest in projects, but nothing is even agreed on that score. So yes there will be £5 billion of spending but out of a budget of £700+ billion, this will be so insignificant it is meaningless. If this fail and it will they will blame Keynesian policy again. If anyone criticises the plan they are accused of talking down the economy and scaring away the confidence fairy. 

  3. Anon says

    Looking at the politics (and the economic projections), I would say that the UK is talking up AUSTERITY, but has no intention of hitting the targets…. 

  4. Anon says

    Looking at the politics (and the economic projections), I would say that the UK is talking up AUSTERITY, but has no intention of hitting the targets…. 

  5. frank c says

    QE3 to the rescue again. How many times more can Ben play this card before the alleged bond vigilantes wake up?

  6. frank c says

    QE3 to the rescue again. How many times more can Ben play this card before the alleged bond vigilantes wake up?

  7. Dave Holden says

    “Now, It’s one thing to tell us that you are uncomfortable about high
    levels of government deficit spending and recommend fiscal consolidation
    despite the very negative near-term impact it will have. But, it is
    quite another story to invoke the mythical confidence fairy and tell us
    that fiscal consolidation will lead to near-term growth because of the
    powers of that confidence fairy. It will not and has not.”

    I used to be of the view that the invocation of “the mythical confidence fairy” was purely a political device – used by those who believe that governments are basically bad at allocating capital – to achieve not a near term growth goal, which was never on the cards, but a medium term one that included a reduced role for government.  The more I’ve got to know these politicians, particularly the UK’s George Osborne, the more I’ve realised they actually believed in it.

    That said achieving a balance between ameliorating the needed private sector deleveraging and blowing up government finances is not an easy hand to play.

    1. Anonymous says

      That is why I think the best solution is to actually pull the rug from under the banks, let them fail, effectively have rapid asset deflation and loan write-offs. It will eliminate much of the debt that is holding back the economy.

      In many ways they got it right in the thirties. We are doing it all wrong now. As it keeps asset prices too high and effectively hampers job creation because so much new business capital is going to buy or rent business assets. While this is great for old businesses as it hampers new competition it is lousy for the economy. 

  8. Dave Holden says

    “Now, It’s one thing to tell us that you are uncomfortable about high
    levels of government deficit spending and recommend fiscal consolidation
    despite the very negative near-term impact it will have. But, it is
    quite another story to invoke the mythical confidence fairy and tell us
    that fiscal consolidation will lead to near-term growth because of the
    powers of that confidence fairy. It will not and has not.”

    I used to be of the view that the invocation of “the mythical confidence fairy” was purely a political device – used by those who believe that governments are basically bad at allocating capital – to achieve not a near term growth goal, which was never on the cards, but a medium term one that included a reduced role for government.  The more I’ve got to know these politicians, particularly the UK’s George Osborne, the more I’ve realised they actually believed in it.

    That said achieving a balance between ameliorating the needed private sector deleveraging and blowing up government finances is not an easy hand to play.

    1. Anonymous says

      That is why I think the best solution is to actually pull the rug from under the banks, let them fail, effectively have rapid asset deflation and loan write-offs. It will eliminate much of the debt that is holding back the economy.

      In many ways they got it right in the thirties. We are doing it all wrong now. As it keeps asset prices too high and effectively hampers job creation because so much new business capital is going to buy or rent business assets. While this is great for old businesses as it hampers new competition it is lousy for the economy. 

  9. swimmer says

    UK “austerity” is caused more by net consumer borrowing falling from about 8% of GDP per year  (1997 – 2007), to about nothing.  I know economists ignore consumer borrowing, but shops don’t.

    1. Anonymous says

      This was called the Paradox of Thrift by Keynes. This is one problem that can be laid at the feet of the previous UK government. Governments relied on the credit bubble to stimulate the economy rather than manage their spending so well and allowing the level of savings to fall. We are now paying for this policy error. Central banks are given the wrong targets to manage. While inflation is an important target it should not be used in conjunction with managing the overall economy. That requires fiscal intervention not monetary intervention. Central banks should also manage total credit and savings levels. If they had done this the housing bubbles would be much smaller, and people would have actual savings to cope with disasters. 

      The problem is that the current UK government are compounding the mistake by failing to keep rates high enough to discourage debt and encourage savings. This might benefit those the banks and with debts but does nothing for pensioners, savers and first time buyers. 

  10. swimmer says

    UK “austerity” is caused more by net consumer borrowing falling from about 8% of GDP per year  (1997 – 2007), to about nothing.  I know economists ignore consumer borrowing, but shops don’t.

    1. Anonymous says

      This was called the Paradox of Thrift by Keynes. This is one problem that can be laid at the feet of the previous UK government. Governments relied on the credit bubble to stimulate the economy rather than manage their spending so well and allowing the level of savings to fall. We are now paying for this policy error. Central banks are given the wrong targets to manage. While inflation is an important target it should not be used in conjunction with managing the overall economy. That requires fiscal intervention not monetary intervention. Central banks should also manage total credit and savings levels. If they had done this the housing bubbles would be much smaller, and people would have actual savings to cope with disasters. 

      The problem is that the current UK government are compounding the mistake by failing to keep rates high enough to discourage debt and encourage savings. This might benefit those the banks and with debts but does nothing for pensioners, savers and first time buyers. 

  11. Stevie b. says

    “For me this speaks to downside risk and P/E compression”

    But….but, show me more than 1 person who’s not bearish ALREADY!!!
    There are no new surprises – it could all be more or less all priced in – ALREADY!!

    As far as the Euro is concerned, unless they bite the unification bullet now, I’d guess that ongoing austerity that makes pips squeak will prove too excruciating for some, when with one tempting bound and a cheeky calculation or two, they can be free. Some quick but crucial devaluations, sighs of regretful but blissful relief and it’s off for another trot round some sort of  cyclical stock-market track.

  12. Stevie b. says

    “For me this speaks to downside risk and P/E compression”

    But….but, show me more than 1 person who’s not bearish ALREADY!!!
    There are no new surprises – it could all be more or less all priced in – ALREADY!!

    As far as the Euro is concerned, unless they bite the unification bullet now, I’d guess that ongoing austerity that makes pips squeak will prove too excruciating for some, when with one tempting bound and a cheeky calculation or two, they can be free. Some quick but crucial devaluations, sighs of regretful but blissful relief and it’s off for another trot round some sort of  cyclical stock-market track.

  13. TINMAN says

    End of an Era: “The era of procrastination, of half-measures, of soothing and baffling expedients, of delays, is coming to its close. In its place we are entering a period of consequences.” — Winston Churchill

  14. TINMAN says

    End of an Era: “The era of procrastination, of half-measures, of soothing and baffling expedients, of delays, is coming to its close. In its place we are entering a period of consequences.” — Winston Churchill

Comments are closed.

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