Seeking Alpha
Long/short equity, value, long-term horizon, hedge fund manager
Profile| Send Message|
( followers)  

Judging from how the markets reacted when our dear leaders finally decided to talk to each other last week, solving the Fiscal Cliff will most likely trigger another rally. That is just brilliant. Markets, which have been going up on any hint of more stimulus, are now rejoicing at the coming austerity.

That's right. Austerity is bad for Europe, but great for the U.S. Go figure. Europeans are just not smart. They should not have left the labeling of their policy to the Germans. Austerity evokes Teutonic discipline. It implies painful sacrifices. We don't want that. Avoiding a cliff sounds much better. It implies great relief.

How are we going to avoid the Fiscal Cliff? By agreeing to reduce government profligacy and increasing taxes. But how exactly is that different from European austerity?

There is something so predictable in economic cycles that only Nobel prize winners cannot see it: after running up the credit card, one has to pay. The Europeans found that out many years ago and are still paying. Japan found that out a couple of lost decades ago and are still refusing to pay. Now it is America's turn to deal with such a predictable problem. How we tackle it will greatly influence the markets for many years to come.

In the U.S., however, we still have one trick up our sleeves to postpone the pain. The Fed calls it the wealth effect. Higher asset prices give people the needed confidence to consume more. It is the stated policy of the Federal Reserve Bank. Bernanke has not been shy about claiming credit for it and he fully intends to continue whatever medicine is needed to keep asset prices up. Call it the Viagra economy, if you know what I mean.

Little blue pills aside, fiscal austerity is coming to a neighborhood near you. The only question is: what form of austerity? Looking around the world, one can indeed learn that not all austerity programs are alike.

First, there is the French version of austerity. Every time the government runs out of money, create a new tax and give it a fancy name. Grow the role of government (with state bureaucrats spending only 56% of GDP*, there is still 44% to go) and blame Indian businessmen.

There is the Irish model (shared with the Baltic countries) of brutally cutting government programs to immediately live within one's means. Raise taxes on individuals, but keep corporate taxes substantially below the average (12.5% in the case of Ireland*). Then, resist the French attempt to bully you into aligning your tax rates with theirs.

The most popular model in Euroland today is the German austerity model. The Spaniards, the Italians and the Portuguese are following it. They all are greatly encouraged to continue to reduce welfare benefits somewhat, increase tax revenues somewhat and combine these measures with a touch of increased labor flexibility. It worked very well for Germany 10 years ago, probably because on a relative basis, it seemed drastic at the time.

Finally, there is the Japanese model: bury your head in the sand.

Sometimes, markets forget to differentiate between all these austerity policies. However, outcomes vary widely. The Japanese model leads to decades of stagnation, even lost generations. The French way inevitably leads to disaster. The German recipe, on the other hand, does not apply to the U.S. Labor flexibility is not an issue here.

The best outcome, looking at recent examples, is when the Irish/ Baltic model is applied. These countries took it on the chin. GDP nosedived. But shortly after, the economy bounced back.

To get the crisis behind us, drastic measures are needed. It will hurt, but it will be short. It will also allow for a huge bounce in a relative short period of time thanks to a strong, new foundation.

This model has a different name here in the U.S. It is called the Fiscal Cliff. Once again, traders are cheering for the wrong outcome in Washington.

Oh, and then there is the Greek model.

*Source: Eurostat

Source: The Viagra Economy Is Not Dead Yet