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Lots of people argue that fiscal policy should be much more restrictive and the U.S. shouldn't run these big deficits for fear that the U.S. will become "like Greece." The latter is a country where deficits and debts have ran amok and the country needed to be bailed out and defaulted on much of its debt.

Well, these people might get what they wish for, as at the end of the year a lot of tax cuts are expiring and some spending cuts kick in, which will provide a fiscal retrenchment in excess of 2% of GDP, if nothing is done before that.

But are they right in arguing that the U.S. should run a much tighter fiscal policy to avoid "ending up like Greece?" We don't think so. What got Greece run into the ground was a combination of severe austerity and a rather unforgiving currency regime, the euro, which isn't unlike the gold standard.

Excess savings

First of all, one should note that the bond markets are not worrying about U.S. deficits and debts. While bond yields have increased a bit on a better economy, they're still extremely low by historical standards. We already hear people arguing that the Fed bought a lot of bonds, but that hasn't made much of a difference. When they stopped doing that, rates didn't shoot up (to the considerable amazement of some).

It isn't hard to explain why. There is a considerable savings surplus in the U.S. The private sector saves much more than it invests, so there really are excess savings that have to go elsewhere.


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The gap is narrowing a bit, but not much. Further, according to the IMF, there is an excess of savings in the world, although it would be preferable to finance the deficit domestically.

Master of your own currency

While the public deficits and debts in the U.S. are indeed about what they were in Greece a couple of years ago, the rates the U.S. has to pay aren't anywhere near. Where Greece had to resort to bail-outs because rates were so high that the fiscal situation became untenable, the U.S. basks in record low interest rates.

The difference is mainly explained by the fact that Greece issues debt in what is essentially a foreign currency, the euro, over which it has no control. Greece can't, in extremes, print euros to pay-off its debt. The U.S. can print as many dollars as it wants so the chances of the U.S. defaulting on its debt are, well, as good as zero.

All this wasn't a big deal and a mere theoretical consideration but when talk of a haircut on Greek debt (the euphemistically named "private sector involvement" or PSI) became more than just a theoretical exercise, investors woke up to this otherwise arcane difference.

Suddenly the myth that sovereign debt from supposedly developed countries were risk free investments was pierced. One consequence was that the euro crisis began in earnest when the consequences had sunk in on the financial markets, which is why we called it Germany's catastrophic euro mistake at the time.

Bond yields began to diverge sharply in the eurozone:


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Suddenly one's public finances seemed to matter a lot less than the fact of whether you were master of your own currency. For instance, the public finances of countries like Spain and Italy were not in worse shape, and in some respects in better shape compared to those of the U.K. or the U.S., but the latter basked in record low interest rates while the former saw their own rates ratchet up quickly.

Gold standard

Many of the people arguing for tight fiscal policy also argue for much tighter monetary policy (decrying Fed "money printing") or even the return to the gold standard. The latter in particular would be a terrible idea, especially in combination with austerity. In many respects, being a member of the European Monetary Union is similar to having your currency tied to gold.

It forces deflationary policies in an already deeply deflationary situation (that is in the midst of a severe economic crisis where real output is way below potential output) without any possible compensation. This didn't work in the Great Depression of the 1930s, quite the contrary:

The gold standard did not create the depression; however, it most likely pushed the country into a depression...The gold-standard mentality and the institutions it supported limited the ability of governments and central banks to respond to adversity; they led to the adoption of policies that made economic conditions worse instead of better.

Indeed, the sooner countries let go of the gold standard, the faster their economies recovered.


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This is what happened to Greece (The Telegraph):

Greece has been subjected to the greatest fiscal squeeze ever attempted in a modern industrial state, without any offsetting monetary stimulus or devaluation.

Now, why is that? Greece's plight is invariably couched in terms of fiscal profligacy (and there is a considerable degree of truth in that, although much less so for the other euro zone countries in crisis). However, much less well known is that by joining the euro, currency risk was removed from investing in Greece, causing a substantial influx of capital.

This produced a bit of a boom (apart from casualness on the part of authorities) and, more importantly, a divergence of competitiveness vis-a-vis many other euro zone countries. Greece (and other peripheral euro zone countries) became uncompetitive as a result and now it's extremely difficult to remedy that.

The straitjacket of the euro produces the same constraints as that of the gold standard in the 1930s for countries which lost competitiveness and experience large current account deficits. One cannot devalue its currency to restore competitiveness, the only way out is severe deflation. That is, reducing most wages and prices, rather than the exchange rate ('internal devaluation').

This is an extremely painful process. Here is the Telegraph again:

Manufacturing output fell 15.5pc in December. The M3 money supply crashed at a 15.9pc rate. Unemployment jumped to 20.9pc in November, up from 18.2pc the month before, and is already above the worse-case peak pencilled in by the Troika.

Some 60,000 small firms and family businesses have gone bankrupt since the summer, the chief reason why VAT revenues dropped 18.7pc in January.

What's more, falling prices have a habit of increasing the real value of outstanding debt. So a country might restore a modicum of competitiveness (slash-burning one's economy in the process), it ends up with a higher debt burden. This is exactly what happened to Greece:


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And to think that there are people out there who think that in an economic crisis, austerity and the constraints of a fixed currency system like the gold standard are a way forward. We would say, the figure above alone should give some pause to think. We cannot think of a more toxic cocktail under the present circumstances..

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Austerity + Gold Standard = Greece