With the "sequester" upon us, it is time to examine the economic impact of austerity. The argument generally states that governments must undergo austerity to credibly bring down their long term debt loads so that the economy can flourish in the future. Unfortunately, IMF research has already come to the conclusion that austerity severely damages economic growth in the near term, and has long term growth consequences. Other countries that have undergone austerity have already demonstrated this.
The prime example of the failure of austerity is Britain. In particular, the Cameron/Osborne government has made austerity a continuing priority even in the face of riots by furloughed or laid off government workers and sustained economic stagnation and even contraction. To combat this economic contraction the Bank of England has had to pursue several aggressive rounds of quantitative easing that dwarf the Fed's efforts per capita. In the face of fiscal austerity, these monetary efforts have been unsuccessful in jump-starting the British economy, thereby forcing the Bank of England to consider yet another round of quantitative easing. What is more disconcerting is that despite the austerity measures designed to bring British debt in line with long term goals, Moody's recently downgraded British debt from AAA to AA+. In essence, this downgrade is a premiere symbol of failed austerity.
As Mervyn King departs from the Bank of England, he signaled that he believes the Bank needs to pursue yet another round of QE, but it is unclear what incoming BOE chief, Mark Carney, will do. Given the widespread (though misplaced) suspicion that we are engaged in a global currency war, it is pretty clear that austerity is counterproductive when attempting to devalue a currency to remain competitive in global trade. This global competition has become paramount as the Eurozone economy lacking monetary or fiscal stimulus continues to shrink and the weak Japanese economy increasingly relies on a devalued currency. Japan has even made their weak Yen goals official with the nomination of Haruhiko Kuroda, an outspoken supporter of currency devaluation, higher inflation targets and fiscal stimulus, to lead the Bank of Japan.
Turning to the potential impacts of U.S. fiscal austerity in the form of the "sequester," it is clear that this policy would be an enormous drain on the economy. Analysis by Macroeconomic Advisers indicates that sequestration would reduce 2013 U.S. GDP growth by 0.6% and cost the economy roughly 700,000 jobs. What is worse is that this economic pain would not send the signal that the U.S. is capable of limiting the growth of our debt, rather it sends the signal that our political system continues to be so dysfunctional that reasonable policies for sustained economic growth cannot be passed.
With the "sequester" upon us, it is time for investors to recognize the gloomy scenario before our economy and protect themselves from losses. Washington is continuing down an obviously dysfunctional path that while not disastrous, it is likely to hamper GDP and employment growth through the rest of 2013. Moreover, equity market growth is likely to be restrained while wild swings in Treasury markets are likely as investors grow increasingly anxious about the political will to find reasonable solutions to problems with U.S. fiscal policy. Investors would be wise to treat this as an equity market plateau and pull out of most stocks while remaining cautious about the slow long term growth of their bond portfolio.