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July 2010

Is Austerity the Road to Ruin?

James Montier

et me share with you one of my guilty secrets:

Ioccasionally indulge in the dark art of macroeconomics. I don’t try to forecast the future (thatwould be truly pointless), but I do think that understandingthe macro backdrop can, on occasion, help inform theinvestment process. For instance, those who understoodthe 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-uptended to plow in and repent at leisure, as the deterioratingfundamentals generated a permanent loss of capital.So why share this confession now? I think we are seeinga very worrying trend around the world: the rise of theAusterians. This breed is the latest incarnation of what

used to be called the decit hawks, a group set uponreducing 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 Bees

) 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

“As this prudent economy, which some people call Saving, is in privatefamilies the most certain method to increase an estate, so some imaginethat, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon awhole 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 givensums. Every such attempt to save more by reducingconsumption will so affect incomes that the attemptnecessarily defeats itself. It is, of course, just asimpossible for the community as a whole to saveless than the amount of current investment, since theattempt to do so will necessarily raise incomes to alevel 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 everyonetries to save more, total income is lowered. If you aren’tspending, then neither are the people who depend uponyou for their source of income. Firms won’t invest if there is no demand for their products, and we end up in anasty downward spiral.An alternative presentation was provided by my goodfriend, Rob Parenteau, in one of John Mauldin’s “Outsidethe Box”

columns earlier this year. Parenteau remindsus that:Domestic Private Sector Financial Balance +Fiscal Balance + Foreign Financial Balance = 0This makes it clear that it is impossible for all sectors tonet save at the same time. As Parenteau notes, this isn’t atheory, it is an accounting identity. If this is wrong, thenso are hundreds of years of double-entry bookkeeping.

http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2010/03/09/the-european-union-trap.aspx

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 BalanceThe 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 privatesector 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 thedomestic 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 spendingmode, then the nancial fragility of the economy islikely 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 lessonsfrom the Great Depression.

Lesson I: Small scal expansion has only small effects.

Lesson II: Monetary expansion can help to heal aneconomy even when interest rates are near zero.

Lesson III: Beware of cutting back on stimulus toosoon.

Lesson IV: Financial recovery and real recovery gotogether.

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

The Great Depression is the subject in which Romer made her professionalname. Full text at: http://www.econ-pol.unisi.it/fiorito/c.romer_rec09.pdf

Fiscal SurplusDPS DeficitCurrent AccountSurplusCurrent AccountDeficitDPS DeficitDPS DeficitDPS SurplusDPS SurplusDPS SurplusFiscal DeficitDomestic Private Sector Financial Balance = 0%

Exhibit 13 Sector Financial Balances Map

Domestic Private Sector Financial Balance = Current Account Balance - Fiscal Balance

Source: Parenteau (2010)

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Is Austerity the Road to Ruin? – July 2010

share the hallmark of being adjustments occurring insmall, 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 thatthe world faces currently.If the examples of history are ignored (as is all too oftenthe 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 ina 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 ahard place. On one side, the Austerians and the (albeitinvisible) bond vigilantes argue that unless governmentsact, there will be sovereign debt crises left, right, andcenter. On the other side, the Keynesians (like me) arguethat tightening will lead to a relapse into recession.

In an effort to nd some common ground between the

warring factions, Olivier Blanchard and Carlo Cottarelli

have suggested the following Ten Commandments for

scal adjustment in developed economies:

Blanchard and Cottarelli, “Ten Commandments for Fiscal Adjustment inAdvanced 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 remarkableresults in terms of real growth: the U.S. economy grew by 11% in 1934, 9% in 1935, and 13% in 1936 in realterms! This lulled the authorities into thinking that allwas 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 turnin 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 unerringability 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 anincipient recovery over the head with overly aggressivetightening measures. Most relevant for the Austerianswas the experience in 1997, when the authorities raisedthe consumption tax by 2% and plunged the economy back into a recession.In fact, Alesina and Ardagna

examined 107 scal

retrenchments in the OECD countries between 1970and 2007. A mere 26 of them occur with growth, whilst

the others are all deationary. The minority essentially

Alesina 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