World leaders from the U.K.’s David Cameron to Naoto Kan of Japan are betting they can deliver fiscal austerity without derailing economic prosperity. History suggests they may be right.
Governments have proven they can spur expansion by focusing their belt-tightening on spending cuts rather than tax increases, according to studies by Harvard University professor Alberto Alesina and Goldman Sachs Group Inc. economists Kevin Daly and Ben Broadbent.
“There have been mountains of evidence in which cutting government spending has been associated with increases in growth, but people still don’t quite get it,” Alesina said in an interview. He made a presentation to European finance chiefs on the topic during their April meeting in Madrid.
Such a strategy in the past has also “resulted in significant bond and equity-market outperformance,” according to an April 14 Goldman Sachs report.
Some investors are cool to the idea so far, and even President Barack Obama is pressing for more stimulus, not less, in the U.S. as he prepares to meet Cameron, Kan and other Group of 20 counterparts at a summit in Toronto June 26-27.
“We must be flexible in adjusting the pace of consolidation and learn from the consequential mistakes of the past, when stimulus was too quickly withdrawn and resulted in renewed economic hardships and recession,” Obama wrote in a June 16 letter to G-20 leaders.
The focus on fiscal policy at the summit will be sharper after China relaxed a two-year peg to the dollar, limiting the likelihood the yuan will be debated at the talks and signaling the global recovery is gaining strength.
“They’ve made their move, which effectively takes it off the G-20 agenda,” said Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics in Washington.
While the MSCI World Index has risen about 8 percent since June 7, it is still about 10 percent below the April 15 year-to-date high, partly because it isn’t clear yet that spending reductions won’t restrain expansion.
“We think it is prudent to remain underweight European sovereign risk and to wait for evidence that countries with stressed debt dynamics can deliver on fiscal consolidation without undermining growth in their economies,” Andrew Balls, head of European portfolio management in London for Newport Beach, California-based Pacific Investment Management Co., wrote in a research report.
The key is an emphasis on cutting spending rather than raising taxes, said Goldman Sachs economists Broadbent and Daly in London. Lower spending means consumers and companies don’t fear higher taxes, so demand accelerates. A smaller public sector also helps reduce borrowing costs and makes economies more competitive as fewer government workers lighten labor expenses.
In a study of 44 large fiscal adjustments in 24 advanced economies since 1975, Broadbent and Daly discovered that reducing expenditures by 1 percentage point a year boosted average annual growth by 0.6 percentage point. Raising the ratio of taxes to GDP by the same margin cut growth by an average 0.9 percentage point.
The equity markets of the countries that sliced spending beat those of other advanced nations by 64 percent during a three-year period, and their bond yields fell by more than if budget adjustments had been driven by tax hikes, according to the report.
“A rigorous approach from governments gives investors much more confidence that policy-setting is meant to be serious,” said Franz Wenzel, a strategist at AXA Investment Managers in Paris, which oversees the equivalent of more than $600 billion. “That is what supports risky assets in general and equities in particular.”
Stock prices also may be bolstered by loose monetary policy as central banks offset the tighter budget stance by keeping interest rates at record lows.
Policy makers will take account of fiscal tightening in deciding when to raise rates, said Simon Hayes, an economist at Barclays Capital in London. Barclays now predicts the Federal Reserve will increase its benchmark rate from near zero in April 2011 instead of September this year, as the investment bank previously forecast, and the European Central Bank will lift its key rate from 1 percent in June next year rather than March.
Hayes last month pushed back his prediction for an increase in the U.K.’s 0.5 percent rate to February from August.
“I know there are those who worry that too rapid a fiscal consolidation will endanger recovery,” Bank of England Governor Mervyn King said in a June 16 speech. “If prospects for growth were to weaken, the outlook for inflation would probably be lower and monetary policy could then respond.”
Too much delay in restoring order to budgets will ultimately spark a market “crisis, which impacts heavily on the economy,” ECB Executive Board member Lorenzo Bini Smaghi said in a June 18 speech in Brussels. “A timely fiscal adjustment which puts debt dynamics back onto a sustainable path entails a stronger growth over time.”
At a June 5 meeting in South Korea, G-20 finance ministers threw out a commitment to keep injecting stimulus into their economies after spending $5 trillion to combat the economic slump. Splitting over how soon the reversal should begin, they settled on a pledge to pursue “growth-friendly” consolidation.
The shift comes as investors punish profligate economies from Ireland to Greece, forcing European governments to create a 750 billion-euro ($924 billion) safety net.
The premium investors demand to hold Greek 10-year bonds over benchmark German bunds has widened 433 basis points since January 1 to 672 basis points on June 21. The so-called yield spread between Irish and German 10-year bonds widened 125 basis points to 270 basis points.
The International Monetary Fund estimates the G-20’s average debt burden will reach 110 percent of gross domestic product by 2015, a 37 percentage-point increase from its pre- credit-crisis level. The average budget deficit was 7.5 percent last year compared with 0.9 percent in 2007, according to the Washington-based lender.
European countries are leading the way in cutting back. Ireland raised a sales tax in 2008, introduced an income levy and reduced public workers’ pay. Greek lawmakers in May approved wage cuts for public workers, a three-year freeze on pensions and a second increase this year in sales taxes.
Ahead of Target
The spending reductions are the main reason Greece is ahead of its target to reduce the budget deficit for this year to 8.1 percent of gross domestic product from 13.6 percent, Prime Minister George Papandreou said in a July 20 radio interview on “Bloomberg on the Economy” with Tom Keene.
Germany’s cabinet this month backed budget cuts worth more than 80 billion euros through 2014. Chancellor Angela Merkel said she expects to have a “hard time” at the G-20 summit as other leaders press her to focus on economic growth. They will tell her “Germany saves too much,” she said June 11, adding she’ll respond that “there is no alternative” to cutting the deficit.
European policy makers aren’t alone in starting to don hair shirts. Prime Minister Kan’s administration today released a fiscal plan that includes pledges to cap spending for three years, reduce bond sales and overhaul the tax system. A Japanese government advisory panel today advocated higher taxes on consumption and high-income earners.
Prime Minister Kevin Rudd has pledged to bring Australia’s budget into surplus in 2012-13, three years ahead of forecast, by keeping a 2 percent cap on spending growth. Indian Prime Minister Manmohan Singh’s government won parliamentary approval in April for a series of tax increases.
Advanced economies need to retrench because issuing more debt will “crowd out” private-sector activity and threaten their credit ratings and long-term health, Thomas Byrne, a senior vice president at Moody’s Investors Service in Singapore, said in an interview.
When the Group of Seven returned their budgets to near- balance in the mid-1990s, expansion averaged a “reasonable” 2.85 percent, Ian Richards, an equity strategist in London at Royal Bank of Scotland Group Plc, said in a May 27 report. Ireland in the 1980s and Sweden and Canada in the following decade corrected fiscal imbalances and their economies expanded.
“The global economy can grow at a robust rate, even as global fiscal consolidation gains momentum,” Richards said.
The shift to parsimony has nevertheless spooked financial markets concerned that simultaneous tightening will return the world to recession. The euro has fallen about 14 percent against the dollar this year, in part because of speculation the euro area’s economic rebound will stall as governments cut spending to tackle the debt crisis.
“Global growth expectations have ‘double-dipped’ and positioning is much more defensive,” Michael Hartnett, chief global-equities strategist at BofA Merrill Lynch Global Research in New York, said in a June 15 report.
It is “utter folly” for the G-20 to be considering retrenchment with unemployment so high, Nobel laureate Paul Krugman wrote in his blog June 6. The U.S., U.K. and Japan also aren’t “facing any pressure from the markets for immediate cuts,” he said.
With the U.S. jobless rate at 9.7 percent last month, Obama is urging Congress to act on measures to boost lending and give tax breaks to small businesses to encourage employment.
Focus on Jobs
“We worked exceptionally hard to restore growth; we cannot let it falter or lose strength now,” Obama wrote in his June 16 letter.
There are already signs that the loss of stimulus packs a punch. French car sales fell 12 percent in May, ending a 12-month surge in demand for smaller vehicles, after the government began phasing out incentives. U.S. housing starts tumbled 10 percent in May following the expiration of a home-buyers’ tax credit the previous month, according to the Commerce Department. The drop was the steepest since March 2009.
“The impact of concerted fiscal tightening over many economies will be to lower global growth meaningfully,” said George Magnus, senior economic adviser at UBS AG in London. “I don’t buy the idea that you shouldn’t be frightened of fiscal retrenchment.”
U.K. Test Case
The U.K., home to the G-20’s biggest budget shortfall, may be a test case. Cameron’s government today introduced an emergency budget aimed at tackling a deficit that reached 11 percent of GDP in the last fiscal year. Spending reductions accounted for 77 percent of the cutbacks proposed by Chancellor George Osborne, who said it was a “false choice” to say policy makers must pick between dealing with debt and going for growth.
“If the U.K. budget is well received by investors and voters, that will have a profound effect on the debate elsewhere,” said Tim Adams, a former U.S. Treasury undersecretary and now managing director of the Lindsey Group, a Fairfax, Virginia-based investment consulting company. “If the U.S. is smart, it will be paying close attention to what happens.”