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GMO - James Montier - Is Austerity the Road to Ruin

GMO - James Montier - Is Austerity the Road to Ruin

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GMO
White PaPer
July 2010
Is Austerity the Road to Ruin?
James Montier
Let me share with you one of my guilty secrets:
I

occasionally indulge in the dark art of macroeconomics. I don’t try to forecast the future (that would be truly pointless), but I do think that understanding the macro backdrop can, on occasion, help inform the investment process. For instance, those who understood the impact of a bursting credit bubble stayed well clear

of the value trap opportunities offered in nancial stocks

during 2008. Those who focused purely on the bottom-up tended to plow in and repent at leisure, as the deteriorating fundamentals generated a permanent loss of capital.

So why share this confession now? I think we are seeing a very worrying trend around the world: the rise of the Austerians. This breed is the latest incarnation of what

used to be called the decit hawks, a group set upon
reducing what it sees as the government’s proigate
spending.
The power of the paradox of thrift
The Austerians either ignore or dismiss the paradox of
thrift. This paradox (which appears rst in the Fable of
the Bees1) was popularized by John Maynard Keynes in
The General Theory of Employment, Interest and Money.
He wrote:
For although the amount of his own saving is unlikely
to have any signicant inuence on his own income,
the reactions of the amount of his consumption
1“As this prudent economy, which some people call Saving, is in private

families the most certain method to increase an estate, so some imagine
that, whether a country be barren or fruitful, the same method if generally
pursued (which they think practicable) will have the same effect upon a
whole nation, and that, for example, the English might be much richer
than they are, if they would be as frugal as some of their neighbours. This,
I think, is an error.” Bernard Mandeville, The Fable of Bees: or, Private

Vices, Publick Benefits,1714.

on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself. It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to

save add up to a gure exactly equal to the amount
of investment.

In essence, the paradox of thrift is a fallacy of composition. Whilst it may be perfectly rational for one household (or section of the economy) to save more, if everyone tries to save more, total income is lowered. If you aren’t spending, then neither are the people who depend upon you for their source of income. Firms won’t invest if there is no demand for their products, and we end up in a nasty downward spiral.

An alternative presentation was provided by my good friend, Rob Parenteau, in one of John Mauldin’s “Outside the Box”2columns earlier this year. Parenteau reminds us that:

Domestic Private Sector Financial Balance +
Fiscal Balance + Foreign Financial Balance = 0

This makes it clear that it is impossible for all sectors to net save at the same time. As Parenteau notes, this isn’t a theory, it is an accounting identity. If this is wrong, then so are hundreds of years of double-entry bookkeeping.

2http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/
archive/2010/03/09/the-european-union-trap.aspx
2
GMO
Is Austerity the Road to Ruin? – July 2010
He creates a useful map to think about the paradox of
thrift (Exhibit 1). The diagram rearranges the equation
above such that:
Domestic Private Sector Financial Balance =
Current Account Balance – Fiscal Balance
The 45-degree line marks the points where the current
account balance is equal to the scal balance, and thus
the private sector balance must be zero. To the left of
this line, the current account balance is less than the
scal balance, and the domestic private sector is decit
spending. To the right, the current account balance is
greater than the scal balance, and the domestic private
sector is running a nancial surplus (net saving).
As Parenteau points out, “The nancial balance map
forces us to recognize that changes in one sector's
nancial balance cannot be viewed in isolation, as is the
current fashion. If a nation wishes to run a persistent
scal surplus and thereby pay down government debt,
it needs to run an even larger trade surplus, or else the
domestic private sector will be left stuck in a persistent
decit spending mode.”
This framework also highlights one of the great ironies of
the Austerian’s approach. If a scal surplus is pursued,
and the domestic private sector is stuck in decit spending
mode, then the nancial fragility of the economy is
likely to increase, raising the probability that more scal
spending will be needed in the future.
The lessons of history

In early 2009, Christina Romer, Chair of the Council of Economic Advisers, gave a speech laying out six lessons from the Great Depression.3

Lesson I: Small scal expansion has only small effects.
Lesson II: Monetary expansion can help to heal an
economy even when interest rates are near zero.
Lesson III: Beware of cutting back on stimulus too
soon.
Lesson IV: Financial recovery and real recovery go
together.
Lesson V: Worldwide expansionary policy shares the
burdens and the benets of recovery.
Lesson VI: The Great Depression did eventually end.
Of relevance to our current concerns are Lessons III and V.
The huge monetary expansion caused by the U.S. leaving
3The Great Depression is the subject in which Romer made her professional
name. Full text at: http://www.econ-pol.unisi.it/fiorito/c.romer_rec09.pdf
3 Sector Financial Balances Map
Domestic Private Sector Financial Balance = Current Account Balance – Fiscal Balance
Source: Parenteau (2010)
Exhibit 1
Fiscal Surplus
DPS Deficit
Current Account
Surplus
Current Account
Deficit
DPS Deficit
DPS Deficit
DPS Surplus
DPS Surplus
DPS Surplus
Fiscal Deficit
Domestic Private Sector
Financial Balance = 0%
Exhibit 1
3 Sector Financial Balances Map
Domestic Private Sector Financial Balance = Current Account Balance - Fiscal Balance
Source: Parenteau (2010)
GMO
Is Austerity the Road to Ruin? – July 2010
3

share the hallmark of being adjustments occurring in small, open economies with weak currencies at a time of generally healthy global growth. These are about as far removed as one can imagine from the circumstances that the world faces currently.

If the examples of history are ignored (as is all too often
the case) then policy error is likely to be a serious source
of deationary pressure.This is the last thing a debt-
laden economy needs, especially a debt-laden economy
that is teetering on the brink of deation anyway. But

that doesn’t mean that policy makers won’t try to tighten. Indeed, one of the world’s worst economists and a paragon of orthodox belief, Alan Greenspan, opined in a recent Wall Street Journal OpEd that “an urgency to

rein in budget decits” is “none too soon.” Did you need
more evidence that this was a really bad idea!?!

One can understand the pressure being placed upon policy makers. They are caught between a rock and a hard place. On one side, the Austerians and the (albeit invisible) bond vigilantes argue that unless governments act, there will be sovereign debt crises left, right, and center. On the other side, the Keynesians (like me) argue that tightening will lead to a relapse into recession.

In an effort to nd some common ground between the
warring factions, Olivier Blanchard and Carlo Cottarelli5
have suggested the following Ten Commandments for
scal adjustment in developed economies:
5Blanchard and Cottarelli, “Ten Commandments for Fiscal Adjustment in
Advanced Economies,” 2010, http://blog-imfdirect.imf.org/2010/06/24/
ten-commandments-for-fiscal-adjustment-in-advanced-economies/

the Gold Standard seems to have produced remarkable results in terms of real growth: the U.S. economy grew by 11% in 1934, 9% in 1935, and 13% in 1936 in real terms! This lulled the authorities into thinking that all was well with the system again. Hence, in 1937, the

decit was reduced by approximately 2.5% of GDP.
Monetary policy was also tightened. As Romer notes,
“… the Federal Reserve doubled the reserve requirement
in three steps in 1936 and 1937… taking the wrong turn
in 1937 effectively added two years to the Depression.”
Lesson V is also of marked interest as the Austerians seem
to have gained a higher degree of inuence in Europe
(including the U.K.) than they have currently in the U.S.

Japan provides us with another example of the unerring ability of policy makers to snatch recession from the jaws of recovery. Time and time again in the post bubble period, the Japanese policy makers have beaten an incipient recovery over the head with overly aggressive tightening measures. Most relevant for the Austerians was the experience in 1997, when the authorities raised the consumption tax by 2% and plunged the economy back into a recession.

In fact, Alesina and Ardagna4
examined 107 scal
retrenchments in the OECD countries between 1970
and 2007. A mere 26 of them occur with growth, whilst
the others are all deationary. The minority essentially
4Alesina and Ardagna, “Large Changes in Fiscal Policy: Taxes vs. Spend-

ing,” 2009; forthcoming in Tax Policy and the Economy, available at:
http://www.economics.harvard.edu/faculty/alesina/recently_published_ale-
sina

Exhibit 2
-10
-8
-6
-4
-2024681991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Consumption tax
increase
Q1-
Exhibit 2
Japan: A prima facie case against premature
tightening (YoY, %)
Source: Datastream
Exhibit 3
-202468
10
12
141980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Jan-
Exhibit 3
G7 Ination (YoY, %) – No margin for error
Source: Datastream

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