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Austerity for posterity?

My father used to give me some good advice as a young boy. Among some of his advice was regarding saving. He would say, “Christian, always make sure that out of every dollar you make in a day, that you always keep at least a penny in your pocket when the day is over”. This concept is so simple yet so powerful over time. This is what enables us to create personal wealth over time.


 
The formula above says that at some terminal time point (NYSE:T) one’s wealth is a function of the sum of the difference between income and expenses for each sub-period (t) over time. Note that income and expenses here are loosely defined as any income and expenses from and to any source including capital gains or losses.
 
When contrasting this wealth concept between public and private sector participants a natural question arises; why do governments miserably fail to run balanced budgets? Well, if I wanted to open a can of worms, I just did. This question is one of the most loaded questions in macroeconomic conversations and has been for many decades. Besides the asymmetry of government policies that favor private wealth creation in conflict with public wealth creation in many economies, part of this has to do with government’s infinite time horizon. I will not go into a discourse about why it is that most governments run deficits but rather emphasize the significance of today’s budget climate in the context of what it means from a broad macroeconomic perspective.
 
In today’s environment, most Western economies (some would called advanced or developed, based on the headlines I would maybe seek an alternative classification and just call them mature and sick) have some budget situation that calls for drastic and painful solutions to right the boat. This requires politicians to have the fortitude to do what is necessary unless they are willing to watch their economies fall off a soaring waterfall. Judging by the average politician’s career aspirations of getting reelected, the can always seems to be kicked down the road for someone else and a future generation to deal with. This is partly the constituent’s fault for being complicit to enabling politicians to make the wrong decisions for short-term gain or “pain reduction”. The need to be responsible and hold politicians accountable has never been greater. Shared sacrifice may be required and we should all be prepared for this and what may be required. That is of course unless we are willing to ignore the long-term effects of inaction and continue down a dangerous road.
 
We are all familiar with the headlines out of Europe, the problems, the causes and the lack of cohesive and comprehensive solution that will solve the root causes that appear to be structural in nature and not cyclical as many think. The U.S. is not far behind in terms of its precarious debt and budget situation. The current climate calls for addressing the problem and not just doing patch work. This secular deleveraging theme unfortunately requires pain unless we are all willing to commit the same prior sins that brought us to this precipice. What caused the mortgage induced credit bust of 2008 has not disappeared. It has only been transferred to a different balance sheet. The catch is that it is now implicitly everyone’s balance sheet – the government’s balance sheet.
 
This begs the title’s question; is austerity here for posterity?
 
The answer to the question depends on what steps ‘we’ are willing to take. In the short-term, pain and sacrifice has to be endured if we want to sustainably change the future’s possible outcomes. This could involve writing off bad debts and marking-to-market and call a spade a spade. This would include debts such as mortgages as well as sovereign. It would likely require government spending cuts or tax increases or a combination of both. It is not entirely necessary to create budget surpluses but rather decrease the ratio of government spending as a fraction of total GDP and decrease the relative servicing metrics in relation to the size of the economy.
 
Austerity has a direct impact on wealth creation across the board. It decreases the rate of wealth accumulation. It does so by either decreasing income, as government spending cuts translate into lower aggregate income, or alternatively increasing expenses in the form of higher taxes or some combination of the two. The argument for a sub-potential growth phase for the economy should be clear given the notion of austerity.
 
Some side effects of austerity are those of crimping consumer and business confidence which could exacerbate trends in the broader macro economy. If consumers decide to save more by spending less due to uncertainty around taxes and the labor front, this can create a self-feeding loop that causes businesses, in turn, to use restraint if not cut back in anticipation of such consumer behavior. Government’s ability to offer support under current conditions may be extremely limited. The argument that consumers and corporations can or will replace the government’s void is questionable given the fragility of these two broad economic sectors.
 
Hence brace yourselves for an extended period of uncertainty and below potential growth with risks of a double-dip seeing higher probability in the near term. Developing economies will likely not be able to counter these powerful forces except for their ability and/or willingness to underwrite our need for debts and time to get out of this mess.
 
Remember to save that penny at the end of the day!