Aug. 3 (Telegraph) -- The US, Britain, and Europe are
together embarking on a sudden and severe tightening of fiscal
policy, in unison, before economic recovery has reached safe
take-off speed. The experiment was last tried in the 1930s.
The theoretical model behind the austerity push – known as
an "expansionary fiscal contraction" – is based on the work of
German theorists, and more recently on studies by Harvard
professor Alberto Alesina and a group of brave scholars willing
to defy the canonical doctrine of post-war Keynesian economics.
The Alesina view has been embraced by the European Central
Bank and the budget cutters of the Eurogroup, but has enraged
America's professoriat and set off a heated argument across the
world.
Former US Treasury Secretary Larry Summers said there is now
a one-third chance of a full-blown recession next year in the US.
Nobel leaureate Paul Krugman said obscurantists had run amok.
"What we're witnessing here is a catastrophe on multiple levels.
We are doing a terrible thing. We are repeating all the mistakes
of the 1930s, doing our best shot at recreating the Great
Depression," he said.
Fear that a synchronized squeeze in half the global economy
may go horribly wrong has seeped into market psychology,
explaining why the $2.4 trillion (£1.5 trillion) debt deal agreed
in Washington has failed to spark a relief rally. Wall Street is
a step ahead, bracing for cuts in an economy that has already
slipped to stall speed.
Angst over faltering recovery explains why Italian and
Spanish bonds have suddenly buckled. The European Commission said
the spike in Latin spreads is "clearly unwarranted" given that
Rome and Madrid are sticking to their austerity plans, but this
misses the point.
Investors no longer see austerity as a solution if cuts go
beyond the therapeutic dose and tip Italy and Spain back into
recession, playing havoc with fragile debt dynamics.
The US is expected to tighten by 2pc of GDP next year,
including the expiry of payroll tax cuts and the phase-out of
President Barack Obama's stimulus plan. Britain is tightening by
1.7pc this year and almost as much next year. Harsher versions
are under way in Ireland and Club Med. Greece is retrenching by
16pc over three years. Canada, France and Germany will all
tighten in 2012.
The International Monetary Fund said the combined effect is
double the last sychronized squeeze in 1980. It comes as China is
curbing credit to cool its property boom.
The Alesina school cites a string of cases where fiscal cuts
led to robust recovery, and a few booms. Their work cannot be
dismissed lightly and exposes the limits of New Keynesian models,
which often clash with historical reality and human behaviour.
The textbook cases are: Italy (1970s); Ireland, Denmark and
Sweden (1980s); Canada, Spain and the UK (1990s). There were some
flops, too: Finland (1970s), Australia, Belgium and Greece
(1980s), and Italy (1990s). Context is crucial. Dr Alesina says
one clear message comes through from the stack of evidence: "Tax
increases are much worse for the economy than spending cuts."
A study by Goran Hjelm from Sweden's Institute of Economic
Research said the formula only really works when countries can
let their currencies slide and export their way out of trouble.
This is not possible for Spain and Italy within EMU, nor for the
combined West at the same time. "We can't all devalue together
and export to Mars," said Jamie Dannhauser from Lombard Street
Research.
Bank of England Governor Mervyn King has called for a "grand
bargain" of the world's major players to ensure that the burden
of rectifying global imbalances does not fall on debtors alone,
which feeds a vicious circle. "The need to act in the collective
interest has yet to be recognised. Unless it is, it will be only
a matter of time before one or more countries resort to
protectionsism. That could, as in the 1930s, lead to a disastrous
collapse in activity around the world," he said.
Fiscal contractions work best in small countries where state
spending gobbles up half of GDP and where confidence has already
collapsed. Getting a grip creates a huge sense of relief. Bond
yields fall far enough to offet fiscal pain.
This hardly applies to the AAA bloc today: Gilt yields are
trading at post-war lows of 2.73pc, while 10-year US Treasuries
are 2.57pc, German Bunds are 2.4pc and Japan's JGBs are 1pc.
Central banks can do little to offset budget cuts when rates are
already near zero, though £200bn of quantitative easing has
cushioned the blow in the UK.
Britain had its own intriguing story during the Great
Depression in 1932 when it passed a draconian budget, yet
recovered well. The trick was to slash rates, devalue by a
quarter and retreat behind imperial tariffs. But by then the
international system had already collapsed.
Of course, rich nations may not have the luxury of spending
their way out of trouble any longer. The Bank for International
Settlements warned last year that fiscal woes are already near
"boiling point" as demographics go from bad to worse and average
public debt surpasses 100pc of GDP. "Current fiscal policy is
unsustainable in every country. Drastic improvements will be
necessary to prevent debt ratios from exploding," it said.
The indebted West is in a frightening bind: damned if it
does, and equally damned if it doesn't.
together embarking on a sudden and severe tightening of fiscal
policy, in unison, before economic recovery has reached safe
take-off speed. The experiment was last tried in the 1930s.
The theoretical model behind the austerity push – known as
an "expansionary fiscal contraction" – is based on the work of
German theorists, and more recently on studies by Harvard
professor Alberto Alesina and a group of brave scholars willing
to defy the canonical doctrine of post-war Keynesian economics.
The Alesina view has been embraced by the European Central
Bank and the budget cutters of the Eurogroup, but has enraged
America's professoriat and set off a heated argument across the
world.
Former US Treasury Secretary Larry Summers said there is now
a one-third chance of a full-blown recession next year in the US.
Nobel leaureate Paul Krugman said obscurantists had run amok.
"What we're witnessing here is a catastrophe on multiple levels.
We are doing a terrible thing. We are repeating all the mistakes
of the 1930s, doing our best shot at recreating the Great
Depression," he said.
Fear that a synchronized squeeze in half the global economy
may go horribly wrong has seeped into market psychology,
explaining why the $2.4 trillion (£1.5 trillion) debt deal agreed
in Washington has failed to spark a relief rally. Wall Street is
a step ahead, bracing for cuts in an economy that has already
slipped to stall speed.
Angst over faltering recovery explains why Italian and
Spanish bonds have suddenly buckled. The European Commission said
the spike in Latin spreads is "clearly unwarranted" given that
Rome and Madrid are sticking to their austerity plans, but this
misses the point.
Investors no longer see austerity as a solution if cuts go
beyond the therapeutic dose and tip Italy and Spain back into
recession, playing havoc with fragile debt dynamics.
The US is expected to tighten by 2pc of GDP next year,
including the expiry of payroll tax cuts and the phase-out of
President Barack Obama's stimulus plan. Britain is tightening by
1.7pc this year and almost as much next year. Harsher versions
are under way in Ireland and Club Med. Greece is retrenching by
16pc over three years. Canada, France and Germany will all
tighten in 2012.
The International Monetary Fund said the combined effect is
double the last sychronized squeeze in 1980. It comes as China is
curbing credit to cool its property boom.
The Alesina school cites a string of cases where fiscal cuts
led to robust recovery, and a few booms. Their work cannot be
dismissed lightly and exposes the limits of New Keynesian models,
which often clash with historical reality and human behaviour.
The textbook cases are: Italy (1970s); Ireland, Denmark and
Sweden (1980s); Canada, Spain and the UK (1990s). There were some
flops, too: Finland (1970s), Australia, Belgium and Greece
(1980s), and Italy (1990s). Context is crucial. Dr Alesina says
one clear message comes through from the stack of evidence: "Tax
increases are much worse for the economy than spending cuts."
A study by Goran Hjelm from Sweden's Institute of Economic
Research said the formula only really works when countries can
let their currencies slide and export their way out of trouble.
This is not possible for Spain and Italy within EMU, nor for the
combined West at the same time. "We can't all devalue together
and export to Mars," said Jamie Dannhauser from Lombard Street
Research.
Bank of England Governor Mervyn King has called for a "grand
bargain" of the world's major players to ensure that the burden
of rectifying global imbalances does not fall on debtors alone,
which feeds a vicious circle. "The need to act in the collective
interest has yet to be recognised. Unless it is, it will be only
a matter of time before one or more countries resort to
protectionsism. That could, as in the 1930s, lead to a disastrous
collapse in activity around the world," he said.
Fiscal contractions work best in small countries where state
spending gobbles up half of GDP and where confidence has already
collapsed. Getting a grip creates a huge sense of relief. Bond
yields fall far enough to offet fiscal pain.
This hardly applies to the AAA bloc today: Gilt yields are
trading at post-war lows of 2.73pc, while 10-year US Treasuries
are 2.57pc, German Bunds are 2.4pc and Japan's JGBs are 1pc.
Central banks can do little to offset budget cuts when rates are
already near zero, though £200bn of quantitative easing has
cushioned the blow in the UK.
Britain had its own intriguing story during the Great
Depression in 1932 when it passed a draconian budget, yet
recovered well. The trick was to slash rates, devalue by a
quarter and retreat behind imperial tariffs. But by then the
international system had already collapsed.
Of course, rich nations may not have the luxury of spending
their way out of trouble any longer. The Bank for International
Settlements warned last year that fiscal woes are already near
"boiling point" as demographics go from bad to worse and average
public debt surpasses 100pc of GDP. "Current fiscal policy is
unsustainable in every country. Drastic improvements will be
necessary to prevent debt ratios from exploding," it said.
The indebted West is in a frightening bind: damned if it
does, and equally damned if it doesn't.
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