How Post Credit Bubble Fiscal Austerity Leads To Depression

by: Edward Harrison

In many ways, this budget-busting spending makes sense due to the huge shortfall in private sector demand as the private sector contracted and tens of millions were thrown out of work. If government had countered this contraction in the private sector with one of its own, a Great Depression was sure to come. An appreciation of the financial sector balances makes this clear. That’s what I was talking about in October of 2009 with "Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”.

But since that time, the US has resisted austerity while the UK has embraced it. In my mind, this is the best real-time economic experiment we can have on what does and doesn’t happen as a result of government spending.

-On Britain’s Austerity and Rosenberg’s Depiction of Obama as Herbert Hoover, Jan 2011

Britain’s economy is a shambles as the negative impact of austerity has been made plain. Now, mind you, it was already clear from a leaked Greek bailout document that expansionary fiscal consolidation has failed in Greece. But now the OECD’s double dip warning for Britain should make this plain to all.

The OECD said in May that it expected the UK to grow by 1.8% next year, but said on Monday that it was sharply downgrading its forecast because public spending cuts, the squeeze on household incomes and a more difficult climate for exporters had weakened the economy.

Double-dip recession: don’t say we didn’t warn you“, says the Scottish New Statesman. Now, It’s one thing to tell us that you are uncomfortable about high levels of government deficit spending and recommend fiscal consolidation despite the very negative near-term impact it will have. But, it is quite another story to invoke the mythical confidence fairy and tell us that fiscal consolidation will lead to near-term growth because of the powers of that confidence fairy. It will not and has not.

UK Chancellor George Osborne believed in the confidence fairy. In his mind, fiscal consolidation would lead to immediate prosperity. That’s why Osborne embarked on fiscal consolidation in the first place. Now that things have gone decidedly pear-shaped, Osborne is panicked. He is doing an about face and talking up 30 billion pounds of infrastructure stimulus. And remember, despite how the governing coalition tries to dress this one up, it is plain to all that this is a stimulus program. It won’t be nearly enough.

In the US, the situation is going to take a nasty turn as well. The super committee fiasco tells you that. As I said in July:

The cuts are coming. The President has assured as much through his misguided rhetoric. We’ll just have to see whether the economy in the US is weak enough that they cause a double dip.

-Post credit bubble fiscal austerity leads to depression

And indeed I believe the US is now weak enough that these cuts will cause a double dip in the US as well.

Europe is cutting as well, not just in the periphery, but also in the core. Austria, France, Belgium, and Slovenia have added to the voices of fiscal consolidation due to the threat posed by the euro zone sovereign debt crisis. They join Portugal, Ireland, Spain, Greece and Italy as fiscal cutters. And remember, it doesn’t matter who does the cutting, private or public sector; over the short-to-medium term at least, cuts decrease consumption demand. When Europe falls into recession, the loss of tax revenue will mean budget deficits will actually increase. If the euro zone dissolves in some way, things will be considerably worse.

So, when we go into 2012, it will be much the same as it was in 2008; Europe, the UK and the euro zone will be beset by recession and a nasty credit crisis will inflict even more damage. The difference between then and now is that the policy options are greatly diminished due to the recession and bailouts that we have already seen.

For me this speaks to downside risk and P/E compression. We are getting a nice trading bounce right now due to the news of a euro solution and Black Friday retail sales in the US. Perhaps this one can run to year’s end due to end of year tape painting. However, in 2012, when what Jeremy Grantham calls “freakishly high” profit margins begin to erode under pressure from this confluence of events in the macro picture, the lower earnings and the P/E compression will mean serious losses for those overexposed to the risk-on equity trade.