Myths of Austerity?

Leo Kolivakis's picture

Via Pension Pulse.

I want
to follow-up on an article Paul Krugman published a few days ago in the
NYT, Myths
of Austerity

When I was young and naïve,
I believed that important people took positions based on careful
consideration of the options. Now I know better. Much of what Serious
People believe rests on prejudices, not analysis. And these prejudices
are subject to fads and fashions.


Which brings me to the
subject of today’s column. For the last few months, I and others have
watched, with amazement and horror, the emergence of a consensus in
policy circles in favor of immediate fiscal austerity. That is, somehow
it has become conventional wisdom that now is the time to slash
spending, despite the fact that the world’s major economies remain
deeply depressed.


conventional wisdom isn’t based on either evidence or careful analysis.
Instead, it rests on what we might charitably call sheer speculation,
and less charitably call figments of the policy elite’s imagination —
specifically, on belief in what I’ve come to think of as the invisible
bond vigilante and the confidence fairy.


vigilantes are investors who pull the plug on governments they perceive
as unable or unwilling to pay their debts. Now there’s no question
that countries can suffer crises of confidence (see Greece, debt of).
But what the advocates of austerity claim is that (a) the bond
vigilantes are about to attack America, and (b) spending anything more
on stimulus will set them off.


What reason do we have to
believe that any of this is true? Yes, America has long-run budget
problems, but what we do on stimulus over the next couple of years has
almost no bearing on our ability to deal with these long-run problems.
As Douglas Elmendorf, the director of the Congressional Budget Office,
recently put it, “There is no intrinsic contradiction between
providing additional fiscal stimulus today, while the unemployment rate
is high and many factories and offices are underused, and imposing
fiscal restraint several years from now, when output and employment
will probably be close to their potential.”


Nonetheless, every few months we’re told that
the bond vigilantes have arrived, and we must impose austerity now now
now to appease them. Three months ago, a slight uptick in long-term
interest rates was greeted with near hysteria: “Debt Fears Send Rates
Up,” was the headline at The Wall Street Journal, although there was no
actual evidence of such fears, and Alan Greenspan pronounced the rise a
“canary in the mine.”


Since then, long-term rates have
plunged again. Far from fleeing U.S. government debt, investors
evidently see it as their safest bet in a stumbling economy. Yet the
advocates of austerity still assure us that bond vigilantes will attack
any day now if we don’t slash spending immediately.


don’t worry: spending cuts may hurt, but the confidence fairy will take
away the pain. “The idea that austerity measures could trigger
stagnation is incorrect,” declared Jean-Claude Trichet, the president of
the European Central Bank, in a recent interview. Why? Because
“confidence-inspiring policies will foster and not hamper economic


What’s the evidence for the belief that fiscal
contraction is actually expansionary, because it improves confidence?
(By the way, this is precisely the doctrine expounded by Herbert Hoover
in 1932.) Well, there have been historical cases of spending cuts and
tax increases followed by economic growth. But as far as I can tell,
every one of those examples proves, on closer examination, to be a case
in which the negative effects of austerity were offset by other
factors, factors not likely to be relevant today. For example,
Ireland’s era of austerity-with-growth in the 1980s depended on a
drastic move from trade deficit to trade surplus, which isn’t a
strategy everyone can pursue at the same time.


And current examples of austerity are
anything but encouraging. Ireland has been a good soldier in this
crisis, grimly implementing savage spending cuts. Its reward has been a
Depression-level slump — and financial markets continue to treat it
as a serious default risk. Other good soldiers, like Latvia and
Estonia, have done even worse — and all three nations have, believe
it or not, had worse slumps in output and employment than Iceland,
which was forced by the sheer scale of its financial crisis to adopt
less orthodox policies.


So the next time you hear
serious-sounding people explaining the need for fiscal austerity, try
to parse their argument. Almost surely, you’ll discover that what
sounds like hardheaded realism actually rests on a foundation of
fantasy, on the belief that invisible vigilantes will punish us if
we’re bad and the confidence fairy will reward us if we’re good. And
real-world policy — policy that will blight the lives of millions of
working families — is being built on that foundation.

Mr. Krugman has been busy lately, appearing on
Charlie Rose
, and on Sunday he took part in the roundtable
discussion on ABC's This Week
, discussing the jobless recovery and
why he was correct that more stimulus was needed in the first package.

also appeared
on CNN's Fareed Zakaria
stating that more needs to be done to shore
up the economy in the form of spending on public works and other
programs. On the flip side, Mr. Zakaria interviewed Harvard economic
historian Niall Ferguson who thinks we need to stop spending and
"radically simplify the tax code" to shore up business confidence. I embedded the video with both interviews below and will go over a few key points.

First, as I have
stated before, implementing austerity measures at a time when private
sector recovery is still fragile is very dangerous and will ultimately
threaten the global recovery

Second, Krugman is right
that austerity will work against governments trying to shore up their
fiscal position. Why? Because if austerity slows the recovery, or worse
still, kills it, then governments will see their tax revenues shrink
dramatically. Imposing austerity measures during a fragile recovery is
akin to engaging in fiscal suicide.

Third, Krugman is right
about Ireland, Latvia and Estonia. They all implemented savage cuts,
unemployment went up, as did the cost of insuring their debt, and
government revenues dwindled. It has been nothing short of a monumental

Fourth, "invisible bond vigilantes" do not pose a
serious threat for the US or even Japanese bond market. Bond vigilantes
can easily pick on Greece, Portugal and maybe even Spain, but that game
has run its course too. The Europeans finally woke up and sent out a
strong signal to speculators in the form of a trillion
dollar gamble

Importantly, the
big, bad bond vigilantes are simply no match for the Federal Reserve and
they know it. Bernanke can squash them like a bug if they get too smug
and start speculating on US sovereign debt.

Fifth, as I wrote in
my last comment, the bond market is more
worried about a 1930s echo
right now, which is driving yields
lower. If they were more worried of massive fiscal crisis leading to a
run on the US dollar, then yields would be skyrocketing up, not down.

I do not agree with all of Krugman's proposals. Spending on public
works is not a long-term solution to bolstering the labor market. You
need to implement a much more radical approach which will target new emerging
industries. I was happy to see president Obama announce that the
government is handing out nearly $2
billion for new solar plants
, but this is a drop in the bucket,
basically peanuts.

Seventh, I think Mr. Ferguson is right that
we need to simplify the tax code, but I prefer a consumption tax which
does not penalize low income families over any flat income tax. Mr.
Ferguson was coy stating that "Keynesian policies were an abysmal
failure in the past". It wasn't Keynesian policies that led to the 1970s
stagflation episode, but supply shocks and funding the Vietnam war
through expansionary monetary policy.

Finally, one thing
Krugman said on ABC's This Week really struck me. He said he doesn't
like the term 'double-dip' because even of the US economy grows at 1%
but unemployment rises to 10.5%, it won't technically be another
recession, but that doesn't mean much to those who are currently
struggling to find work.

We are at a crossroad. Millions of
unemployed people are losing hope, waiting for policymakers to come up
with a program targeting job growth. Instead, all they are seeing is
political feuding that doesn't address the central core issue - jobs.
It's as if politicians have run out of ideas and go with whatever the
latest poll tells them is the flavor of the day. The lack of leadership
from politicians and business leaders during these unnerving times is
truly disheartening.

Let me end by wishing all my US readers a
Happy Fourth of July. As bad as it gets, never lose hope in America.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Popo's picture

I'm not sure how Leo arrives at his size-comparison for the bond market vs. the Federal Reserve -- but by my math it's no "squash them like a bug" scenario at all.

For every chip the fed throws on the table, the bond market can throw in 10 chips of magically produced, leveraged funny money.

How are the bond vigilantes "no match" for the Fed again?



Dismal Scientist's picture

Quite so. 94% of Jap govt debt is domestically owned by the Post Office, insurance companies etc. This is why the JGB market has not collapsed even with over 200% debt/GDP ratio, and why neophytes continue to get blown up advocating shorting Japanese debt. Unfortunately the same cannot be said for the US...

Leo Kolivakis's picture

"Remember Soros squashing the Bank of England like a bug?"

Yeah, who can forget, he came close to losing it all, but came out stinking rich. Trust me, nobody will ever be able to pull that off with the Fed.

maddy10's picture

So US can print for ever or until USD loses currency status

People are so naive!

' there is no alternative the USD'

Creating alternate fiat currency in the present day and age of supercomputing is a minute's job or even less'

The world can consider all surpluses as dollar equivalents in new currency and move on

The military consequences of such action is the only hindrance for something of that sort from happening

So wake up coz that day won't be too far if you keep pushin'


Hdawg's picture

Ah Soros, another of Rothschild's whores.

What followed next? Tony Bliar and the 'independence' of the Bank of England.

Soros will get his.

Hulk's picture

Hdawg, I am no fan of Soro's, but all he did was take advantage of a very stupid government. The strong most always rule over the weak, whether physical or minded...

Carl Marks's picture

Another Fabian Socialist.

hungrydweller's picture

Yup - Leo has emptied the Kool-Aid bowl and has nowhere to piss but here.

TBT or not TBT's picture

When we read Krugman, and Leo commenting on Krugman, that's all the faith we need to get up out of bed and really go to work. Pure motivation. The primacy of the state is THE dream baby.  The very essence of incentive, mainlined.   Growth of government is like viagra to the individual actor, from overtaxed overegulated private sector employee, to paid-not-to-work underemployed "worker", to unfirable gravy train porn watching unionised government employee.   An eternal incentive circle jerk.

Shameful's picture

Oh don't worry, the US won't pick the austerity road till it is forced on us. 
It'll be trillion dollar deficits till the worlds tells us to fly a kite.  The problem is we cannot follow Krugman's requests because he would just keep moving the target higher.  If we kicked another 500 billion in, he would call for another trillion, another trillion and he would call for 5 more, and so on.  In this way he can always have the defense "The stimulus wasn;t big enough.  It should have been 1 * 10 ^32 dollars"

In the immortal words of Buzz Lightyear "To infinity (debt) and beyond!"

ozziindaus's picture

Thank you Leo. Your argument makes good sense in respect to where government spending of public money should be channeled. Hi tech is the way to go and it's the governments duty to release technologies discovered using public money through GSE's, NASA the DoE etc. They don't just owe it to us, they are obligated to release it. 

I do however disagree with the following comment. 

Importantly, the big, bad bond vigilantes are simply no match for the Federal Reserve and they know it. Bernanke can squash them like a bug if they get too smug and start speculating on US sovereign debt.

The so called "vigilantes" may be crushed alone by the Fed but the bond market is not only comprised of a few like minded individuals but instead span globally and wield greater power than any single private organization. 

But let us assume that the US government was to stimulate through PRODUCTIVE private sector investments. The spending may (arguably) drive UST yields up but what exits the US government bond market will enter into corporate bonds. Corporations that are likely to benefit from the government stimulus of course. UE will likely drop and markets for new technologies open driving consumption, exports, services, tax receipts and therefore GDP. 

The key to growth is innovation and invention. 

Everything that can be invented has been invented. Charles H. Duell, 1899

maddy10's picture

That's the point!

Krugman, Leo and like are shouting aloud

Normal laws of economics do not apply to US which is above everyone else because Bengono can print money and the world will tremble with fear

IMF and Neocons have been preaching the same Austerity con for latam countries,Africa for past 30 years

and now it has become a taboo once so called developed economies are in trouble

who are these bond vigilantes'?

the bond buyers and owners who ask for higher rates to rollover and buy new debt

I think its mostly US and European banks that own these sovereign bonds which were bailed out by these govts in first place

Looks like the Ponzi scheme owns everything

I don't understand why other countries are still going along with USD

cdskiller's picture

Bang! Exactly. I gotta say, I get so tired of Mr. Krugman, sometimes, because he naively resists drawing the obvious conclusions of his own observations. He thinks policy makers act on their beliefs. That is spectacularly naive. It has not become conventional wisdom that now is the time to slash spending. Wisdom has nothing to do with it. Neither does evidence or careful analysis.

Yet, what Krugman foolishly concludes is that calls for austerity are the result of sheer speculation and fear of imaginary bond trader ghosts. No, Professor. They are the result of carefully considered political calculations. Calls for austerity in recessionary times, against all defensible economic theory, and following a period of massive fraud, the greatest expansion of the gap between rich and poor in history, and the transfer of fiscal responsibility for the risk inherant in an asset bubble from the creators of that bubble, BONDHOLDERS, onto the average taxpayer-

is evidence of capture, not superstition. Someone has to pay the piper. Senior bondholders and market makers have made it clear to policy makers that they refuse to be that person. Policy makers, on their knees, lubricated with cash, knowing which side their bread is buttered on but needing to appear strong, start talking about the tough love of austerity.

Clearly the only long-term answer is to eliminate the mechanisms and the instruments with which bond vigilantes can threaten to wreak havoc and the political need for policy makers to enslave themselves to ruthless criminals.

dnarby's picture


If we debase the currency too rapidly, won't they just quit buying our bonds?

I sure wouldn't, since there's no assurance you're going to get a return which exceeds the inflation rate.

WaterWings's picture

They better hurry up with that Cold Fusion idea. It's about to look like Ukraine 1930's around here!

dnarby's picture


That will bridge us to fusion, hot or cold, or solar (once it gets above 50%, which may happen sooner than later...) or...  Whatever!

Because it doesn't matter as we have 1000 years of proven thorium reserves!

Cheeky Bastard's picture

Dude; bond vigilantes can crush a smaller nation into oblivion with no more than 3 billion dollars. Cash positions [and shorting of bonds old style] are dead concepts; amateur trades; give me 2B and a comparably low spread on some nation with small to average debt and I can make it look like Greece in 6 mths.Shit; thats whats is being done to Norway as we speak; and to Finland also. No idiot cap-arbs a sovereign; you either go short [with stop losses in place] or long; you dont hedge.

ozziindaus's picture

I framed my argument in respect to the US bond market. $3B will represent 0.1-0.3% of yearly UST issuance depending on government figures. Liquidating bonds for USD's, or a more ballsy approach of shorting them, may just as quickly squeeze you into insolvency in this economic environment where preservation > yield. I do not fear the vigilantes to raise US interest rates. Their threats are subdued by their mere insignificance with respect to the US's colossal debt market. It would take a concerted effort by global bond investors to the shake the market but I just don't think it would happen anytime soon. China's dumping of the long end proved that. 

Cheeky Bastard's picture

Im not talking about borrowing bonds and shorting them via conventional mechanism. What is this; 1989? You have the necessary tools to short 80% of debt outstanding of a smaller nation/volume by not spending more than 3B dollars [and that is probably too high of a figure] over the course of whatever time period you wish.

As to what those "tools" are; well you should know by now. If you read my original comment more carefully; you will see there was no need for yours. Also, I wasn't talking about UST volume outstanding of cash bonds; but about volumes which are three figure multiples lower than UST.

hammel123's picture

Are you one of those people who believes Soros "broke" the bank of England? You think you can open a large enough default swaps position against a country at your own discretion?


Cheeky Bastard's picture

Are you one of those morons who think that a) CDS existed in 1992 b) CDS have ANY relation to FX [ you will find out what outright stupidity that is on your part] c) Soros used [at the time] non-existing non-correlated product to broke a currency which was "wreckable". No he [well I would rather say Druckenmiller, but it doesnt mater] broke the pound because he had access to higher leverage than BoE. Pound got deservedly broken since BoE cretins rushed into a peg which everyone at the time have seen as long-term unsustainable. Re-unification just gave Soros the excuse and "tools" to bet on BoE stupidity.

Not only do I know that you can, as you say "open a large enough default swaps position against a country at your own discretion", but Its basically being done hourly; and you dont need a large positions against/for; just thin volume. For reference look up the trading patter in GRE CDS when CDS went above 1100bps [10% increase in one day] on non-existing volume. Theoretically you should have a non-arbitrage correlation between cash and CDS; you dont; you exploit that; or just short the shit out of cash with CDS.

cdskiller's picture

+1 And that, my friends, is what is referred to as a facial.

ozziindaus's picture

I guess I just don't understand it mate. Too technical for me. After all I'm just a schmuck engineer with a vision of technical innovation and not the financial type. 

Cheeky Bastard's picture

What we have now is not finance; its a Casino. Finance died somewhere in the late 70s; after that its all bullshit and producing commercially viable safety nets [think SPs and derivatives].

That said; I will always put manufacturing in-front of any other economic activity. Manufacturing is the base; the rest; auxiliary industries; derivatives of manufacturing. But that age is gone for the US. Sadly or not; i can not say; I have no emotional interest vested in the US.

Thorny Xi's picture

Cheeky, I think everyone's missing the forest for the trees around here. There is a primary economy that is failing for the first time in 300 years, an economy that finance people and economists just don't seem to even be aware of anymore. The natural energy and natural goods needed to produce the secondary economy, which is based upon the value addition of labor - and the tertiary economy - money and credit.

Cheap, vastly powerful energy availability has been so expansive and reliable, and energy is the backbone of the primary economy, that everyone seems to have forgotten about it. Reading here and elsewhere, all I see is folks quacking that the imaginary constructs of the tertiary economy are somehow real and that by jerking around these variables we can "adjust" the secondary economy - employment and human productivity - as well. As long as the primary economy is growing, we have been able to pull this off. But, the planet's oil energy, a vast inheritance we've now burned halfway through, to the point that the primary economy's "banking" costs are crashing the secondary and tertiary constructs, won't be growing anymore. Fiddle as you will with CDS and high tech solar stuff (all production of which is based on cheap global oil) - the outcome will not change.

What was it Apollo (the statue, not the hedge fund)once told his followers? "You are going to have to change the way you live."

DR's picture

Thats why all this austerity talk is crap-eat beans so WS can have steak?

The social contract is broken and the system is going down..

Take what you can, where you can, while you can..