Is Austerity The Solution To USA's Problems?

Includes: SPY, UPRO
by: Macro Investor

Investors in the USA woke up today (Feb 15, 2013) to more troubles from the eurozone. Reports the Guardian:

GDP figures show the eurozone lurched deeper into recession in the fourth quarter, when even the robust German economy contracted. German GDP dropped 0.6% in the fourth quarter, compared with expectations of a 0.5% decline.

Austerity is simply not working in the eurozone. The people know this. There are mass protests all around, and even the IMF (not exactly a bastion of neo-Keynesians) now believes that austerity in the eurozone has gone too far for too long.

Champions of austerity should stop for a second and think about what this means. The IMF has historically been the most austere of them all. Remember the Asian currency crisis in the late 90's? The IMF systematically went around imposing austerity on the Asian Tigers and caused crushing depressions. The only country to stand up to the IMF was Malaysia which imposed currency controls instead, and came out of the crisis just fine without needing to have a crushing recession.

It is the same IMF that now believes that austerity in the eurozone has been, for lack of a better word, completely wrong. Reports the Nation:

At its semiannual meeting in Tokyo in October, the IMF announced that the austerity packages applied throughout southern Europe since 2009 have been counterproductive, undermining economic growth and increasing rather than bringing down public debt ratios.

Meanwhile protests keep erupting all over Europe. Even the mighty Germany that is the architect of all this austerity is not immune. Reports

Four days of actions from "Blockupy Frankfurt" culminated today in a demonstration of 25,000 against the misery of troika-led austerity.

Note that the eurozone recession is in the face of extremely accommodative monetary policy per ECB President Mario Draghi's statement last week in the ECB Press Conference. Reports Business Insider:

Draghi took the opportunity today to emphasize on multiple occasions that the ECB's monetary policy stance remained "accommodative."

So there is no other avenue left on which to blame the crushing recession that Europe is falling into. It is very simple, really. It is the completely nonsensical notion of trying to run budget surpluses in the midst of the worst global recession in many decades. This ends up hurting those most at need. Reports CNBC:

European austerity measures are punishing the most vulnerable members of society and threatening the entire social cohesion of Europe, according to a report from the charity Caritas.

"The prospect of long term austerity measures, given high levels of child poverty, youth unemployment and long term unemployment, could be a recipe for not just one lost generation in Europe but several lost generations." Caritas Europa's study into 'The Impact of the European Crisis' said.

CNBC is not exactly left leaning. Even they have no choice but to acknowledge that austerity does only one thing well. It punishes the poor and crushes the economies that practice it. It doesn't do it for a short while. It does it for generations.

How could so many smart people in the European governments get things so wrong? At the core of it, there is a general reluctance on part of the so-called rich European nations to subsidize the so-called poorer ones. This, of course, is what happens when there is a monetary union without a fiscal union. Imagine what would happened in the USA if the same policies were practiced?

United States is a rich country, but all the states are not equally rich. Some states get far more back in Federal spending than they pay in Federal taxes, while others get far less. Reports the Economist magazine:

Some American states receive more in federal spending than they pay in federal taxes; others receive less. Over twenty years these fiscal transfers can add up to a sizeable sum. From 1990 to 2009, the federal government spent $1.44 trillion in Virginia but collected less than $850 billion in taxes, a gap of over $590 billion. But relative to the size of its economy, Virginia derived a smaller benefit from America's fiscal union than states like New Mexico, Mississippi and West Virginia, where the 20-year transfer exceeded 200% of their annual GDP.

This is America's way of helping states in need.

(Click to enlarge)

Ironically, the states receiving the most Federal subsidy are generally politically conservative, and in general favor austerity. Under a system like the eurozone, these states would have had to "live within their means" thus completely destroying their economy and in turn their social fabric. Thankfully, USA doesn't subscribe to the notion of austerity. Faced with the Great Recession, the Obama government has expanded spending even as that has led to record budget deficits. The Federal Reserve has helped the government run such large deficits at a low cost (i.e., interest rate) by pumping massive amount of liquidity in the system through Quantitative Easing.

What is the net result of all this? American investors woke up this morning to another piece of very good news. Jobless claims not only dropped, but they dropped far more than expected. Reports the New York Times:

The number of Americans filing new claims for unemployment benefits fell more than expected last week, raising the prospect that the sluggish labor market recovery may have picked up a bit. Initial claims for state jobless benefits dropped 27,000 to a seasonally adjusted 341,000, the Labor Department said on Thursday.

The contrast across the pond couldn't have been more stark.

So, what does this all mean? It really means that the preachers of austerity would do well to read up some Keynes.

In the 1930s, Keynes spearheaded a revolution in economic thinking, overturning the older ideas of neoclassical economics that held that free markets would, in the short to medium term, automatically provide full employment, as long as workers were flexible in their wage demands. Keynes instead argued that aggregate demand determined the overall level of economic activity, and that inadequate aggregate demand could lead to prolonged periods of high unemployment. He advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic recessions and depressions.

It is unfortunate that nearly a hundred years after Keynes so many people in the world are still having to suffer needlessly from the orthodoxy of austerity.

Regardless, I am happy to be an American, and more so an investor in the U.S. market. The Federal reserve has pledged to keep QEternity going till unemployment falls below 6.5%, and is willing to let inflation rise above the targeted range in the process. The Obama Administration is fighting to keep spending cuts at bay. Given that, I remain bullish on the U.S. stock market. I would recommend investors to turn away from the mess that is the eurozone, and invest in the USA. (This, in turn, may actually help the eurozone economies by putting downward pressure on the euro.)

I believe the current period of monetary stimulation in the USA is quite unique. I had earlier written an article that predicted a S&P 500 (NYSEARCA:SPY) of 1872 by year end because of the salutary effects of QEternity. To profit from this, I hold January 2014 calls on the 3x leveraged ETF on SPY (NYSEARCA:UPRO), as well as UPRO itself.

This market, fueled by massive amounts of liquidity being pumped by the Fed, aided by a fiscal policy that rejects the dogma of austerity, has legs.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choice.

Disclosure: I am long UPRO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.