Markets

Barry Eichengreen Nicely Explains Why Austerity is a Size that Does Not Fit All

By Carter Dougherty

Updated on: July 14, 2010 / 6:00 PM EDT / MoneyWatch

If you've been wondering why budget cuts make sense in Greece but not in the U.S., Barry Eichengreen has the answer for you. With a simple metaphor he has shredded the case for Germany's -- and apparently Washington's -- unfortunate turn toward austerity.

Insofar as the proponents of austerity make arguments (some, like Sen. John Kyl, simply insist that we should cut taxes but not extend unemployment benefits) they contend that fiscal consolidation will improve confidence, leading to greater economic growth. There is little evidence that markets are demanding budget deficit reduction from the US anyway, but as places like Greece are getting to work, Eichengreen, a professor of economics and political science at UC Berkeley, gives us a useful way to wrap our heads around what ought to be happening:

Consider the following image: consumers and investors as passengers in a car hurtling directly toward a brick wall. In this case, the driver stepping on the brake will give the passengers more confidence.
Here, the plausible passengers are southern European firms. They understand that their countries' fiscal positions are unsustainable. They know that debt default would be disruptive. Seeing the economy hurtling toward a brick wall, they are holding their collective breath, while evidence that the government is serious about stepping on the brake can induce them to exhale. In this case, fiscal consolidation is likely to affect their investment spending positively.
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But what might work in southern Europe has no chance of working elsewhere. In other G-20 economies, including the United States, Germany, China, and Japan, the car is still cruising down an open road. Fiscal velocity may be considerable - that is, deficits may be large - but there is no sign of a brick wall ahead. Interest rates on government debt are still low. If the passengers were growing restive, they would rise. At this point, they have not. In these countries, there is therefore no reason to think that fiscal consolidation would have a strong positive effect on confidence.

Given the desperate search for sustainable demand in the world economy, we need to bear in mind who can contribute and who cannot. Solvent, creditworthy governments -- yes. Countries on the brink of default -- probably a bad idea. Put another way: if the facts on the ground are different, then different policies are called for.

Shoot, even the Federal Reserve is showing signs of stirring. In the minutes of its last meeting, released today, the Fed included the word 'deflation," an important change in tone from its previous get-together. Fed officials probably live in fear of a U.S. government that actually starts cutting spending right now, as it would force them to take the prospect of falling prices even more seriously.

Can you go head and cut government spending even if you don't need to? Sure. But these days, that would be like building a brick wall -- and driving into it deliberately.

Image from Joriel "Joz" Jimenez via Flickr Related: