The Age of Austerity

by: Dr. Scott Brown

Excerpt from Raymond James Economist Dr. Scott Brown's latest economic commentary:

The European debt crisis encompasses many issues, including problems in the construction of the monetary union. However, the main catalyst has been concerns about government budget deficits (Greece, Portugal, Spain, Ireland). The solution, which should be considered a least-worse alternative, is austerity – cuts in government spending and tax increases for specific countries. Such moves dampen the pace of economic recovery and, in some cases, may lead to recession. The U.S. is not Greece. The U.S. budget deficit is currently very high (roughly 10% of GDP), but should decline as the economy recovers and temporary spending (the bank rescue and the fiscal stimulus) fade. The bigger problem for the U.S. federal budget deficit lies 10 to 20 years out, as Medicare expenditures are projected to surge. At the state and local level, budget deficits are leading to tax increases and cuts in government services. The trick will be to trim deficits without dampening growth too much.

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On May 9, European finance ministers agreed to a stabilization fund, worth up to €500 billion, to be supplemented by an additional €250 billion from the International Monetary Fund (which brings the total size to roughly $1 trillion). Swap lines between the U.S. Federal Reserve, the European Central Bank, the Bank of England, the Bank of Canada, and the Swiss National Bank were reopened. These moves and the size of the EU/IMF stabilization fund caught speculators off guard – at least, for a day. A lack of details and the realization that the problems were still there soon sent global equity markets down again. The EU/IMF plan has merely bought some time. The challenge will be to use that time wisely. The response from global investors does not appear to be optimistic.

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So how does the U.S. budget situation compare to Greece? Greece’s budget deficit had been projected to rise even further as a percentage of GDP in the years ahead. In contrast, the U.S. budget deficit is expected to fall to about 3.5% of GDP in four or five years, as the economic recovery leads to a rebound in revenues and temporary spending fades. Longer term projections are more worrisome. Demographic issues (the retirement of the baby-boom generation) may require minor adjustments to Social Security, but Medicare spending is projected to rise sharply (and this is nothing new, we’ve know about the problem for many years). We need a credible plan on how to deal with the situation in the years ahead.