Very good observations. The 'fiscal contraction expansion' arguments that austerity proponents put forward are demonstrably incorrect. But this isn't just some academic argument, these are ideas which guide real world policy decisions which causes economic hurt and suffering (higher unemployment). The are tons of examples, like here, here and here.
The observation below fits in the same category:
- Western developed economies have been largely affected by balance sheet recessions, that is the private domestic sector over the last decade took out significant debts (typically to participate in the housing boom) and now that asset prices have crashed are repairing their balance sheets, which means saving.
- Mainstream economists have consistently misdiagnosed this (just as they denied there was no housing bubble to begin with) and called this a banking crisis, not a private sector debt crisis.
- Under this advice from a flawed diagnosis, governments underwent significant deficit spending to bail out the banking system (in US, UK, many EU countries), which unsurprisingly (to those of us who understand the core problem anyways) did not fix the problem because the core issue is still not being addressed.
- With 'debt/gdp' ratios rising (which is meaningless, see here) many countries voluntarily (UK under Cameron) or involuntarily (Greece, Spain, etc. under Maastricht rules) have undergone austerity under the theory that the government by running these deficits was 'crowding out' private investment (based on the loanable funds theory) and when the government cut back spending then the private sector would step in.
- This is completely fallacious analysis (beside the loanable funds theory being completely wrong) because the private sector being in a balance sheet recession is in no position to support economic activity via increased spending (spending = income). They are rightfully busy paying down debts by saving a large portion of their income. Which means the government sector needs to continue to run deficits to spend (= private sector income) so that the private sector can realize their savings desires.
- We are absolutely nowhere near a demand-pull inflation environment right now, so the inflationary risks of running deficits large enough to support aggregate demand and support saving desires of the private sector is extremely small.
- And what's worse, is that when governments engage in austerity, debt ratios go *up* because tax revenue falls as economic activity declines and the private sector retrenches.
These observations bear out in the data below. The US has not embraced austerity (not yet at least), but the EU has and the decoupling is coincident with the implementation. Correlation does not necessarily equal causation, but if you understand the drivers as I lay out above, then the cause and effect are clearly understood below:
THE EUROZONE DECOUPLING….
1 May 2012 by Cullen Roche
One of the more controversial ideas I wrote about last year was the decoupling of Europe and the USA. My thinking was that austerity was setting Europe apart from the USA who has not been imposing such austerity and that this divergence was leading to a decoupling of the economies. The more recent PMI reports show this trend becoming more pronounced. Our friends over at Sober Look have more details:
The equity market went vertical this morning on the back of the US ISM Manufacturing PMI coming in stronger than expected (54.8 vs 53 expected).
…What’s striking about this rise in the manufacturing PMI is the divergence between the US and the Eurozone manufacturing trends (chart below). This does not mean the US has decoupled from the Eurozone’s crisis (because manufacturing is still a relatively small component of the US output). But it does provide further support to the forecasts that the US will manage to avoid another recession, at least in 2012.
Manufacturing PMI – US vs. Eurozone (Bloomberg)