Austerity vs. Stimulus: Damned Either Way?

by: Cliff Wachtel

At the highest corporate and government levels, there is confusion about how to heal national and global economies. The US and Japan lean towards further stimulus. The EU and UK are pursuing austerity.

As I tried to sort it out, here’s a summary of the arguments, track record and risks of each. Dear Reader, I welcome your input (and so should our economic elites, who clearly share my uncertainty).

The Basic Argument Against Austerity

On a private individual level austerity makes sense. However it is not as applicable to governments because spending cuts reduce GDP and tax revenues and risk making a recession worse. That’s expected in the short term, but the risk is that the economy never escapes the spiral of lower GDP making debt reduction harder if not impossible. Even if austerity would ultimately work, democracies may lack the political will to stay the course until it works, if the economic suffering provokes enough popular opposition.

The metric everyone is watching is the debt/GDP ratio.

So the big question becomes, when austerity plans take effect, will debt shrink faster than GDP so that debt service costs drop and national finances can return to health.

Greece Brief Case Study

An August 18th Der Shpiegel article suggested that while Greece has made great progress cutting debt, it nonetheless may be entering a death spiral in which GDP may fall too fast for Greece to pay even its reduced spending obligations and debt service, making recovery impossible without outright bailouts, defaults, or debt restructure.

The report noted that some areas are suffering from 70% unemployment, businesses are closing, tax revenue needed for closing the budget gap is falling, and that social tensions are reaching a boiling point. Together these raise doubts about not only whether austerity will work for Greece, but even if it ultimately could, can Greek society bear the pain before abandoning the program before meaningful improvements occur. See here for the full article. Many credited the report with contributing to the general market drop the following day, particularly in the Euro.

Meanwhile, the European Commission announced last Thursday that Greece’s budget reduction justified payment of the second tranche of €9 bln ($11.57 bln) in Euro-zone financial aid in September, deferring any immediate Greek crisis for a few months, though Greek bond and CDS rates are once again spiking towards Spring 2010 crisis levels.

Ireland Brief Case Study

Ireland has been a poster child for voluntary adherence to strict austerity programs. However it’s not making progress in restoring its government balance sheet to health.

News of a new Irish bank bailout on August 11th officially ended the Euro’s summer rally, sending it, and markets in general, sharply lower. The bailout was correctly seen as adding significantly to Ireland’s sovereign debt burden. Ireland still managed to stage a successful bond auction, though it’s unclear if demand was genuine or via ECB manipulation to restore shaken confidence. On August 23rd Standard and Poor’s downgraded Ireland’s credit rating from AA+ to AA, with a negative outlook. That means more downgrades could follow. On August 23rd it was reported here that Ireland’s bond spreads (over German bunds) are now back to crisis levels seen in May.

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Spain Brief Case Study

Spain has also been making vigorous efforts to rein in its deficits, with similar effects on GDP. It too is seeing rising CDS spreads that will complicate its recovery. See here for a detailed look at Spain’s deteriorating growth and debt situation.

Other Austerity Opponents

There have been additional repeated reports (by assorted economic heavyweights like Nobel Prize winning economist Joe Stiglitz) questioning whether austerity measures will not only fail to restore nations to fiscal health but may make their economies even weaker, throwing them into double dip recession or outright depression

Nomura Bank Chief Economist Richard Koo has also argued extensively that the nature of the current global downturn, a ‘balance sheet recession,’ characterized by the bursting of a debt-financed asset price bubble that leaves many private sector balance sheets with more liabilities than assets, cannot return to self-sustaining growth until private sector balance sheets are repaired, which requires continued stimulus. See here for details.

Pro-Austerity Arguments

Here’s the short version. The Keynesian pro-stimulus approach has also failed to produce thus far in the current crisis, if in fact it ever really worked in the past, and the end result is likely to be worse than that of austerity. Stimulus merely delays the collapse until the time when bond markets no longer accept the sovereign debt that funds the stimulus at affordable rates (or at least threatens to do so soon). When it comes, the collapse is much worse due to the accumulated mountain of debt and deeply devalued currency. No nation has ever inflated their way into prosperity.

In response to Richard Koo, David Merkel responds:

Ridiculous. He is arguing that we need to follow Japan’s path of useless stimulus and more government debt. Do we have to see the US govt debt market fail through default or inflation?

You can’t escape the need to liquidate debts. Economies don’t work well at high debt levels. Until total Debt/GDP gets down to 1.4x, we won’t see strong growth. The depression did not end because of FDR’s policies, or WWII, but because debts got paid down and compromised. By 1941, total debt/GDP got down to 1.4x, and stay near there for the next 43 years, which were years of rapid growth in the real economy not led by leverage. The period 1985-2009 saw the enormous growth in debt up to 3.7x GDP, which now has produced our current crisis.

Stimulus thus far in the US, EU, and UK has also failed to spark unequivocal recovery, and recent data suggests the US and most of the EU may be tipping back into recession, if in fact they ever exited it. Concerning the US, Dave Rosenberg of Gluskin Sheff says the US has remained in recession.

Andy Xie argues against stimulus programs here, essentially because capital released winds up flowing to emerging markets where production costs are lower and demand growth is higher, thus failing to aid the intended economies and sparking inflation in the emerging markets that will ultimately spread to the still stagnant developed world economies.

Conclusion: Which Is The Lesser Evil? Depends Which Risks You Fear More

It is not clear whether austerity or continued stimulus is the way to go, and the confusion appears to be at the highest private and official levels, with the US opting for more stimulus and the EU and UK enacting austerity. Neither has worked thus far, but advocates of both approaches would argue that merely more time is needed to prove their approach correct.

What is clear is that neither stimulus nor austerity has worked yet. Meanwhile here is a summary of the risk each approach presents.

Austerity: Kill off nascent recovery so that GDP fails to grow faster than debt falls, locking the economies into a death spiral of lower GDP, inability to pay off debts or even the need to add debt. Meanwhile contracting growth and unemployment risk social unrest and political instability. Current examples of failed austerity thus far include Ireland and Greece.

Stimulus: Has yet to provide conclusive recovery, though advocates say it has averted a much worse contraction thus far. Opponents argue that crash has merely been delayed and will be worse due to the massive additional debt burden and/or currency devaluation and possible hyperinflation if liquidity is withdrawn too late. The argument is somewhat complicated because Quantitative Easing involves giving money to banks, and that money can neither cause inflation nor aid recovery if banks choose to simply retain the funds to repair their own balance sheets and/or refrain from all but the safest lending. At some point, once recovery gets moving, they will start lending, and that is when the inflation risks start, unless central banks are adept at quickly withdrawing the liquidity from bank coffers.

Disclosure: No Relevant Positions