"The public is an idiot," declared French General, the Marquis de Galliffet, as he stared down a rebellious 19th-century Paris. One can imagine Andrea Merkel, Germany's president and embattled fiscal hawk, echoing the sentiment after Europe, led by a new generation of insurrectionist French, rejected spending cuts for stimuli in the name of eurozone recovery.
It was a populist if decisive dismissal of Merkel and the cudgel of her austerity doctrine. After years of slashed budgets and high interest rates, voters in May turned out a slate of leaders with a pro-growth agenda built on renewed public spending. In non-eurozone Britain, meanwhile, Prime Minister David Cameron's own dose of fiscal restraint had delivered nothing but prolonged recession and rising inflation. Once lauded as the eurozone's salvation, austerity is now blamed for hastening its dissolution. "When one steps back and looks at the dynamics in play," argued a post-election blog post in The Economist, "it becomes clear that the robotic push for national-level austerity across the euro zone is undermining integration and thereby exacerbating the process."
News of austerity's demise has yet to reach the United States, however. There, the policy divide has only deepened as the nation enters the home stretch of a coarse and polarizing presidential campaign. Republican Party contender Mitt Romney, having chosen the libertarian-leaning Paul Ryan as his running mate, has transformed the race from a political battle over how to reignite the economy to a Chautauqua-style lecture circuit about the proper role of the state, particularly as it relates to entitlement programs. Democrats, led by the incumbent President Barak Obama, are struggling to revive a Depression-era tradition of activist government; Republicans, meanwhile, would shrink the federal government until it could be "drowned in the bathtub," as anti-tax crusader Grover Norquist has put it.
The argument for immediate fiscal consolidation goes like this: America's federal debt, the estimated $16 trillion in outstanding obligations issued by the U.S. Treasury, is equal to just over 100 percent of its gross domestic product. Social Security, Medicare and Medicaid, which account for two thirds of the federal budget, will soon implode under the weight of baby-boomer retirees. Foreign investors will lose their nerve, unload their trove of U.S. Treasury bills and collapse the economy.
Sadly, this doomsday scenario is not terribly far-fetched. It is altogether possible that investors may one day become net sellers of U.S. federal debt, perhaps even in haste. Such a reckoning is a distant prospect, however, and would be more effectively forestalled through targeted public spending and easier, not tighter credit. The public may be an idiot in some matters, but it is not alone in rejecting spending cuts and high interest rates for a sick economy. A half-decade since the global economy began its spectacular collapse we are still, more or less, all Keynesians. The point is whether pro-growth enthusiasts, be they Obama or France's new president, the Socialist François Hollande, are wise and courageous enough to put on the brakes and start swinging the budget axe once growth becomes reality. The question begs a hearing now, before the age of easy-money finally slips below the horizon line, changing everything.
With the amount of central government debt among OECD nations averaging more than 55 percent of gross domestic product, and with aging populations placing their public health and pension systems under enormous strain, it is vital for the developed world to unwind a generation of leverage. To do so during a time of retrenchment and high unemployment, however, would stifle growth along with revenues, eroding whatever investor confidence deficit reduction might have engendered. Twice in the last four years, in spring 2008 and again in 2011, for example, the European Central Bank raised interest rates in response to a temporary rise in inflation driven by arcing commodity prices, smothering a prospective eurozone recovery. As Nobel Prize-winning economist and New York Times columnist Paul Krugman admonished, "The ECB famously overreacted to a temporary, commodity driven bump in inflation, raising interest rates as the world economy was plunging into a recession.... By all means, let's balance our budget once the economy has recovered - but not now."
In September 2011, an International Monetary Fund report based on data going back thirty years concluded that fiscal austerity lowers incomes in the short term, largely for wage-earners, and increases long-term unemployment. The stress and pain of consolidation intensifies if, as is the case among eurozone member states, central banks are unable to deflate their currencies to enhance export competitiveness. If several countries simultaneously cut spending and raise interest rates, according to the report, "the reduction in incomes in each country is likely to be greater, since not all countries can reduce the value of their currency and increase net exports at the same time."
In response to the argument that fiscal tightening assures investors of a state's creditworthiness, thereby priming it for increased investment and domestic demand, the IMF study concluded that "on average, the effects [of consolidation] are contractionary, with no evidence of any surge of consumption and investment."
As if in validation of the IMF's warning, investment bank Morgan Stanley this month reported that a renewed contraction in eurozone economic growth "seems more probable" due to "additional austerity measures [and] a continued funding squeeze." Conversely, it credited loose monetary policy for assisting much of the eurozone and Britain to finance budget deficits at low interest rates. "This has enabled fiscal policy to act as a stabilizer and remain growth-supportive," according to the analysis.
However discredited in Europe, a plurality of Americans have made fiscal restraint a rallying cry in the campaign to unseat Obama. Despite pressure from a Republican-controlled Congress, the President has not only resisted the Merkel doctrine, he has urged his German counterpart to stimulate consumer demand in her own country to fuel export sales from the eurozone periphery. In response, the German finance minister encouraged "Herr Obama" to get on with the reduction of America's public debt which is "higher than that in the eurozone."
For many fiscal conservatives in America, that is enough to make deficit reduction the nation's top priority even at the cost of an unemployment rate hovering at just over 8 percent. Otherwise, they warn, the bond market will demand higher returns in exchange for investing in U.S. public bonds. In fact, private as well as public investors have been hungrily buying up treasuries at miserly yields almost since the financial crisis began. Some are even accepting negative rates - effectively paying Washington for the privilege of holding its bonds in the hope that one day the government will see fit to give them their money back.
Even a downgrade of U.S. government debt, issued by rating agency Standard & Poor's in August 2011, could not dissuaded investors from betting on, rather than against, Washington's ability to make good on its obligations. Nor does the Federal Reserves' policy of "quantitative easing," under which the central bank has purchased trillions of dollars worth of federal securities, seem to bother the bond markets. Given the economic crisis in Europe, the seemingly endless malaise in Japan, and the illiquid debt markets of China and the Persian Gulf states, there are few places for investors to park their money that provides the security of America's high-volume capital markets. That, plus the U.S. dollar's pre-eminence as the world's reserve currency, allows Washington to borrow and spend its way to recovery almost with impunity. But for how long?
Eventually, the eurozone will recover. If a leitmotif in this spring's elections was the repudiation of austerity, so too was popular support for the eurozone generally, as isolationist candidates were sidelined. The fragility of their institutions duly exposed, eurozone elites must now construct a regulatory framework worthy of a global currency. Recapitalizing the European Investment Bank, for example, would stabilize debt markets and make funds available for so-called "project bonds" to finance fresh infrastructure. (The European Commission estimates that an investment of €230 million could generate €4.6 billion worth of projects.) Member states have endorsed in principal the creation of the so-called European Stability Mechanism, essentially a bailout fund that would provide a firewall against contagion from stricken member economies. Germany, now the de jure economic and political epicenter of Europe with all the responsibility such status confers, will inevitably ease credit to lubricate domestic demand.
Just as Europe will rise intact from the ashes of the current crisis, So too will emerging markets regain the momentum they conceded to low-wage China even before the financial crisis shut down their primary markets overseas. Having mistaken export receipts as an end, rather than a means of modernization, developing economies produced the same goods for ever-dwindling returns. To elude the middle income trap, they must nurture local consumption and diversify sources of growth. Saudi Arabia, for example, having leveraged its fossil fuels resources to develop upstream industries like petrochemicals production, is now investing in mineral extraction and invigorating its financial sector. Neighboring Abu Dhabi is retooling itself into a regional hub for university and post-graduate education while its sister emirate, Dubai, is finally rebounding from its 2010 property collapse.
That leaves China. Having averaged double-digit growth for three decades, the Chinese economy is losing steam. Its overheated property market, fueled by the same easy-credit terms that inflated asset bubbles in the developed world, could collapse with ruinous effect. Rising wages are eroding export competitiveness and a growing number of manufacturers are relocating their factories abroad. Until now, China's leaders have skillfully reconciled the demands of modernization with their insistence on political and intellectual control. But their margin for error has narrowed precariously and the presumption of China's successful evolution into a stable, developed economy can no longer be taken for granted.
There is one thing, however, that Beijing is doing right, with potentially huge consequences for the global economy: it is reforming its currency into fully convertible unit of exchange. In June, Joseph Yam, the former head of Hong Kong's de facto central bank, suggested it should consider dropping the local currency's thirty-year link to the dollar and re-pegging it to the Chinese renminbi. The dollar link, he said, obliged Hong Kong to outsource monetary policy to Washington, which contributed to the former British colony's soaring inflation rate and property prices.
Yam's remarks, which The Financial Times described as "a sign of China's increasing economic dominance in Asia," was also an early inflection point in the diminution of the dollar's role as the world's reserve currency. Over the last eighteen months, Beijing has opened overseas exchange centers in Hong Kong and Singapore and more are planned as trading volume soars. China is now the world's second largest economy and its gross domestic product is expected to exceed U.S. output by 2020. It is only natural that an internationalized renminbi would rival the dollar as the world's fiat currency, which would end the era of dollar hegemony and with it the U.S. government's entitlement to low borrowing costs.
To argue that weakened and highly indebted economies can spend their way to recovery without courting default is not to suggest, as did America's last Republican vice president, that "deficits don't matter." It is both possible and desirable to heal stricken economies without draconian spending cuts that are likely to extinguish the host they were meant to restore. That is the lesson from Europe, and Washington ignores it at its peril. Only then can the U.S. prepare itself for the truly daunting new age to come, one in which the writ of dollar dominion is no longer redeemable.
This essay was co-authored by David Young, CEO Anfield Capital Management, and Stephen Glain