All around the world, governments quake in fear at the threat of a bond market revolt lead by the elusive 'bond market vigilantes'. 'Bond market vigilantes' is a euphemism for bond investors that demand higher yields from sovereign borrowers that are way past their credit limits (i.e. running large budget deficits). Greece and Ireland are two recent victims, and having seen the fallout from these two relatively small countries governments around the world are doing their best to appease the vigilantes.
As a result, many governments around the world are implementing austerity measures to bring budget deficits under control.
I am theory-agnostic (often theory-ambivalent) when it comes to economics. I agree that governments can't rely on Keynesian deficit spending forever. The government debt hangover from stimulus measures used to prevent the 2008/2009 recession from becoming a depression is leaving many with an aversion to government spending. However, I also realize that governments have a role in filling the void, while the private sector gets its act together. And with unemployment around 9%, one can hardly say the private sector is buzzing with activity.
Unfortunately, we live in a world where political grand-standing trumps logical debate. So, without really knowing if it's the right thing to do, the U.S. is taking its first steps towards austerity. (Don't get me wrong, these first steps are pretty pathetic attempts at reigning in the budget deficit. However, these first steps might mark a trend that will persist for the foreseeable future.)
The same pattern (bust, boom and echo-bust) emerged during the Great Depression (see first chart below). A massive crash was followed by an overstimulated boom that stoked political rhetoric over deficit spending. After the 372% post-collapse boom, the president at the time, Roosevelt, was under tremendous political pressure to shrink the deficit, since the recovery appeared self-sustaining (sound familiar?). In 1937 Roosevelt attempted to balance the budget. Subsequently, the DJIA experienced an echo bust and plunged 49% as the austerity measures pushed the economy head-first back into recession.
It appears we may be repeating the same pattern today (see second chart). We experienced a devastating crash followed by a fiscal and monetary-stimulated boom. Now, in 2011, the US government is beginning (i.e. the process is just starting) to manage its deficit, the market has started falling and the economy is rolling over.
I'm no die-hard Keynesian, but I do believe in evaluating all possibilities before taking action. Perhaps the bond market - with the 10yr below 2% - is indicating that the world still has significant appetite for US debt. Perhaps now isn't the right time to cut spending, and the U.S. isn't under imminent threat of attack by the vigilantes. I don't know and anyone who claims that they do is either deceiving you or themselves.
Honestly, whether austerity is needed or not isn't the point. The point is that it is happening in the middle of a quasi-depression at the same time as the post-collapse boom seems to be ending.
So are we about to experience our version of the post-collapse austerity induced echo bust? Will the market crash again like it did in 1937?