Where are we in the investment cycle? What are the global growth and inflation figures telling us about asset allocation?
by Michael Collins, Investment Commentator at Fidelity
“Pain. But no gain” was how The Independent newspaper of the UK summed up the grim news on the country’s economy one day late last year.1 Unemployment had jumped, the Bank of England had slashed growth forecasts and Treasury had forecast that the sluggish economy and rising joblessness would boost government debt beyond previously projected levels.
“Pain. But going backwards” would have been a more accurate (though less lyrical) assessment of the austerity squeeze of David Cameron’s government. The coalition has slashed spending and raised taxes to tackle a budget deficit that stood at 8.5% of GDP in 2011 and to lower government debt from 73% of GDP, even though the country was under no pressure from bond investors to do so. “Those who argue that dealing with our deficit and promoting growth are somehow alternatives are wrong,” Cameron said in Davos in 2011.2
The economic news out on November 16 showed otherwise, as has data since. The jobless rate surged to a 15-year high of 8.3% in the third quarter (2.6 million out of work). The Bank of England cut the growth forecast to just 0.9% for the year to June 2012. The Office of Budget Responsibility revealed that net public borrowing targets had, in effect, been blown three years off course and past Labour’s 2010 predicted peak. Austerity is hardly a political-winning strategy because it prompted two million public servants to strike on November 30, the UK’s biggest industrial action for at least 30 years.
The UK’s experience is another testament to how austerity plans all over the would over are worsening government finances while inflicting misery – the fiscal compact 25 European countries signed up to on January 30 will legally hinder them from using fiscal stimulus to spur their economies. They prove that Keynesians have a better recipe for repairing government finances over the medium term. The big flaw of Keynesian economics in practice is more subtle though.
Reality versus ideology
The Keynesian medicine for tough times is the counterintuitive solution of boosting government spending because economic growth and some inflation are the best ways to prune public deficits and debt. More people in jobs means higher tax revenue and lower spending on social security, the opposite of what austerity does. Austerity is even more pointless if a country’s trading partners are inflicting the same pain, or monetary policy can provide no help for an economy in the form of reduced interest rates or a lower exchange rate.
Europe, from Portugal to Ireland and Latvia to Greece, provides endless evidence against austerity, especially the eurozone countries. The terms imposed on Greece as part of its rescue packages included such fierce spending cuts and tax increases that they have made the country almost ungovernable while ruining its economy – Greece’s GDP shrivelled 5.2% in the year to September, manufacturing slumped 15.5% in December from a year earlier and unemployment is already 20.9%. At the same time, these austerity policies have destroyed government finances. Greece’s ratio of government debt to GDP has soared from 110% in 2010 to about 160%.
Once this ratio reaches 100%, it’s difficult for it to decline unless a country’s economy is growing at a faster pace than the average interest rate on government debt. Since austerity crushes growth, its adherents appear ideological as they stress how cutting government spending will give business the confidence to invest. Nobel-prize-winning economist Paul Krugman dismisses proponents of austerity for believing in the “confidence fairy”.3
Bond investors and rating agencies took little time to work out that austerity damages economies and worsens government debt positions. Hence the vicious cycle of rising bond yields damaging government finances leading to higher yields, which prompts a rating downgrade, leading to higher yields and so on. So austerity can lay claim to bringing on the eurozone debt crisis. A columnist in the right-wing The Telegraph of the UK has labelled Germany’s finance minister Wolfgang Schauble as the “most dangerous man in the world” for his push to enforce “a reactionary synchronised tightening” on Europe’s sick economies.4
Critics of Keynesian solutions cite examples of when economies grew through austerity packages. But usually the circumstances differ from today’s (and some even question the stats that prove economies grew under austerity).
Economists at the IMF recently studied 173 episodes over the past 30 years when 17 advanced economies took steps to fix government finances. While the study’s conclusion was that austerity boosted unemployment (and hence failed to mend public finances), Ireland in 1987 and Finland and Italy in 1992 coped under austerity. This was because large currency depreciations boosted net exports, or lower interest rates supported consumption and investment. “Unfortunately, these pain relievers are not easy to come by in today’s environment,” the authors said.5
The critics of fiscal stimulus say the US government’s US$780 billion package failed to reignite the US economy, even if it helped avoid a depression. It’s true the US economy has only wobbled along since the stimulus was approved in 2009. The problem was, though, that the package was never big enough and was poorly designed. It was about half the size needed and contained incremental tax cuts and only glacial increases in public works. Any good it did was offset by reduced spending by state governments.
The Australian government’s response to the global financial crisis in late 2008 and 2009 is an example of a well-constructed stimulus package. The “go hard, go early, go household” cash and building stimulus propped up the economy and meant the government undershot its own debt forecasts. The federal government’s debt to GDP was only 7.7% in 2011. (To those who think China saved Australia, authorities in Beijing kept China going with a stimulus package worth 16% of GDP.)
One worry now for the Australian economy is that the government is wedded to having a surplus in 2012-13. This will mean sizeable cuts to government spending, estimated at $11.5 billion over four year. At least, the Reserve Bank of Australia has scope to cut interest rates to keep the economy going.
Advocates of Keynesian economics probably feel vindicated by what’s happened in recent years. But there is one flaw to how Keynesian economics is practised.
The flipside to Keynesian economics is that during good times governments should run surpluses and reduce debt to curb inflationary pressures. If they do this, they save their firepower for tough times. The problem is this tends not to happen.
The US, UK, France, Italy and Greece are guilty of running structural deficits during the good times leading up to 2008 (though Ireland and Spain ran budget surpluses before 2008 and had reduced government debt to between 30% and 40% of GDP – the real cause of the eurozone debt crisis is the current-account imbalances of countries on a fixed-currency regime). France, with its generous social security, last posted a budget surplus in 1973. That’s not usual for Europe. In aggregate, the countries in the eurozone have been in deficit for the past 40 years.6 The US government under President George Bush thought it could wage trillion-dollar wars while reducing tax rates for the wealthy.
These governments are in trouble now because they had to bail out banks and other industries and boost social security after Lehman Brothers collapsed in 2008. The US federal government’s deficit in 2011 was about 9.6% of GDP, its ratio of government debt to GDP at 73%. France’s government’s shortfall was about 5.9% of GDP in 2011, while its ratio of government debt to GDP was 81%.
Australia could afford stimulus in 2008 and 2009 because government debt was low thanks in so small way to the previous government’s asset sales (rather than to any impressive spending discipline).
When the good times return, that’s when it’s time to demand prudence from governments. Not now. Even Cameron’s government is realising, sort of, that austerity is a self-fulfilling prophesy. By the end of November, it was talking of a plan to invest in infrastructure to avoid a recession, but further squeezing the public sector and the poor to do so.
All government debt figures to GDP are net. Financial information comes from Bloomberg unless stated otherwise.
1 The Independent. “Pain. But no gain.” 17 November 2011. http://www.independent.co.uk/news/uk/home-news/pain-but-no-gain-6263358.html#
2 David Cameron, Prime Minister of the UK. Full transcript | David Cameron | Speech to World Economic Forum Annual Meeting 2011 | 28 January 2011. NewStatesman. http://www.newstatesman.com/economy/2011/01/europe-world-growth-values
3 Paul Krugman. “Myths of austerity”. The New York Times. 1 July 2010. http://www.nytimes.com/2010/07/02/opinion/02krugman.html
4 Ambrose Evans-Pritchard. “Spaniards battle against an EU death spiral”. The Telegraph. 21 November 2011.
5 IMF. “Painful medicine”. Finance and Development. September 2011, Vol 48, No. 3. Laurence Ball, Daniel Leight and Prakash Loungane. http://www.imf.org/external/pubs/ft/fandd/2011/09/Ball.htm
6 Ric Battellino. Deputy governor of the Reserve Bank of Australia. Speech entitled “Europe’s crisis develops, what happens next?” delivered to the 24th Australasian Finance & Banking Conference. 4 December 2011 reprinted in full on abc.net.au. http://www.abc.net.au/unleashed/3732632.html
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