Coming soon to the USA: Austerity

by David Gerlitz on July 26, 2011

Coming soon to the USA: Austerity.

One thing I know for sure is that the mainstream media and politicians all understate the effectiveness of fiscal policy on the economy. This is based on an (understandable) ideological bent against Government. Unfortunately, a deeper exploration of the economic framework makes clear the Governments role as provider of savings for the private sector.

So, the flip side of this is that they overstate the benefits of spending cuts. Is there such a thing as overstating the benefits of spending cuts? There is a simple rule of economics that Spending=Income. Cut spending and you will cut incomes, there’s no doubt about that. Furthermore, businesses aren’t gong to suddenly show up and start hiring because they now have confidence in the US to maintain a strong dollar. They’re waiting for customers. Customers who aren’t going to suddenly show up if you cut their incomes.

Coming soon to the USA:  Austerity

With that as a background, Edward Harrison of Credit Writedowns has a great article: “Investing in a World of Austerity” that I highly recommend you read in its entirety. He sees an economy coming which is growing at less than 2%, higher unemployment, margins and earnings at companies getting compressed which leads to losses in equities and is bullish on Treasuries. He also thinks we’re finally going to get a wave of municipal defaults.

The thing I’m trying to get to with these posts is that you have to pay attention to the accounting identities which are inherent in the economic system. Reduced government spending also reduces private sector income and savings. You can take one look at the UK, Greece and Spain for the last couple of years and determine that austerity does not work in reducing Government deficits; it only makes them worse. This is because as the spending cuts make their way into the economy and incomes go down, the government budget automatically picks up the slack through transfer payments. Attempts at deficit reduction become self-defeating.

While the USA has not had austerity to this point since the Great Recession began, the debt ceiling debate is going to usher in austerity one way or another. The only question that remains is: how bad will it get and how quickly?

I’m a Real Estate investor and don’t really care for trying to time the market, even if I do have a pretty good idea of what is coming, but let me hazard a guess at what is coming up: I expect a bit of volatility in the markets the next couple of weeks while the extent of the austerity gets sorted out. Its earnings season so the markets will ride the wave of earnings reports as well. Once a deal is in place, the markets will breathe a sigh of relief that default (and catastrophe) was averted. After that, I expect a decline as the markets price in the austerity we are going to get.

If we do get a delay which leads to a short term default, then we’ll see immediate losses while investors run for cover, and without treasuries as the place to run, it will be to precious metals. This would likely be short-lived however, as once an agreement is in place, it’ll be back to the meager, but safe (again!) returns of Treasuries.

At that point, the Eurozone will take center stage. Given that mainstream economists, media and politicians are unable to see the error of their ways, the resulting recession in the US will get blamed on an external shock from the Eurozone or slowdowns in other emerging markets and not on the direct cause:  Government spending cuts here at home. We’re closer to this right now than many think.

Here’s Edward: Investing in a world of austerity – by Edward Harrison

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