Indebted Western Countries Need To “Bend The Spending Curve” – The Pace Of Austerity Does Not Matter, As Long As Bond Markets Believe That It Is A Real Long Term Policy

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By Paolo von Schirach

October 29, 2012

WASHINGTON – Austerity, yes or no? Too much, too little? Does it do any good? Does in fact make things worse? Ask the average Greek, you get a negative answer. Ask the average German, you get another.

Too much public spending

The odd thing is that we are even debating this so much. Austerity really means frugality, doing with less public spending. And why the need? Well, because we spent too much. And this not about one crazy binge.

This is about systemic overspending justified in the name of providing needed social services. In other words, elected officials put their countries on a path of unsustainable social spending, (pensions, health care, unemployment benefits, disability programs, subsidies), in order to please the voters, giving the impression that the financing of this fiscal insanity was actually possible for an indefinite future. As simple as that.

But it was of course impossible. And finally bond markets got the idea and shunned the debt of overextended countries and/or started demanding punitive interest rates that would make it impossible for them to keep borrowing, given the higher cost of debt service.

In Europe, bail-outs with the promise of spending cuts

In Europe the debt crisis has been dealt with via extraordinary new lending to the semi-bankrupt countries –yes, we are talking about Club Med– with the proviso that they would reform public spending, and this means mostly social spending cuts now and in the future, so that total government spending will be realigned with actual revenue.

Nobody can object to this formula. This is like your uncle saying that he will pay for your long and expensive detox treatment, as long as you promise that henceforth you will stop drinking and doing drugs. Otherwise, the detox therapy, (the bail out money, in Europe’s case), is just money down the drain.

How much austerity?

If we establish this, then the only issue that needs to be settled is the pace of austerity implementation. And here it gets tricky, because we do not have a one size fits all template. Ideally, policy makers want to convey to the bond markets that they will “bend the spending curve“. The speed of spending cuts does not matter that much, once markets are convinced you are actually going to do this (bending the curve) and once they really believe that there will be no change of heart somewhere along the line.

If public spending is indeed on a steady downward path, then the peril of insolvency leading to bankruptcy fades away, and investors will reduce their demands for higher interest rates in order to buy your bonds.

Of course, we need to consider other factors. If the overall economic conditions are very weak, then there is no sense in having too much austerity, all at once. Too much austerity means a sudden aggregate demand drop . And this is recessionary. Some austerity will be enough, as long as the overall plan of bending the spending curve remains credible as a long term strategy.

Hopeless cases?

That said, for all this to work, we need a patient with more than just a pulse. To go back to the guy in detox, what if he is too damaged? What if he can never get healthy again? Well, in this case it is all in vain. The expensive detox treatment serves no purpose. And I fear that this is Greece. Likewise, if the patient has no intention of giving up the bottle after detox, he’ll get in trouble again, and we are back to square one. And this is Italy, I am afraid.

America still in denial

America is in a different place. It really needs to bend the entitlement cost curve, just like the Club Med countries. But there is less pressure to do so, because for the moment it is relatively easy to finance a gigantic US national debt, ($ 16 trillion, and counting), at a very low cost. But this gravity defying act can last only so much time. What is unsustainable will not be sustained, as economist Herbert Stein used to remind us.

Just like a functioning alcoholic

Still, for the moment America behaves like the functioning alcoholic who, no matter how much booze he drinks, can still get up in the morning and go to work. We know that he is an alcoholic who will eventually fall on his face; but he does not grasp this, or pretends not to know.

After he does fall on his face, the only issue is how badly injured he will be. It could be that the damage he inflicted to himself is in fact crippling.

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