Keep up spending- Who?s right? Europe or America?

July 1st, 2010

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Sometime last year, we were discussing with someone in the finance ?industry? about the possibility of a double-dip recession. Back then, the mainstream assumption was that government spending will somehow ?stimulate? the private-sector of the economy. But we argued that this assumption was simply incorrect. As we wrote in August 2009 at Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch.

Based on this faulty assumption, the financial market?s expectation is that the worst of the GFC is well and truly over and that the global economy will return to ?trend growth.? But as we wrote in January 2009 at Soft landing hope built on faulty framework assumptions,

Built into the blinkers of the mainstream neo-classical economic framework, the assumption is that the economy is like an elastic band that will spring back to its previous un-stretched state of ?equilibrium? after being stretched by external ?shocks? (e.g. global financial crisis). For those who studied economics at university, you will realise that the phrase ?external shock? is often used in the text-books to describe phenomena that are beyond the scope of economic model. Furthermore, you will find that your text-book are full of simultaneous equations, which implies some sort of ?equilibrium? has to unquestionably happen.

Today, there is a lot of talk in the financial markets about the threat of a double-dip recession. The expected (assumed is the more accurate word) recovery in the United States seems to be stalling. China is enacting policies to slow growth. Europe is mired in sovereign debt problems.

But for you, our dear readers, all these should not come as a surprise. As we already wrote in March this year at Black Swans lurking because Uncle Sam has less margin for error,

If the right word is used (e.g. ‘crutch,’ ‘prop up’) to describe the counter-productive government policies of spend, spend and spend, then it will do wonders to increase the economic IQ of the masses (see Are governments mad with ?stimulating??). Consider this very simple chain a logic:

  1. Someone is falling.
  2. You place a crutch to prevent him from falling.

Isn’t it plain common sense to see that once you remove the crutch, that person will crumble? From this, it follows that government crutch (‘stimulus’) lifts government expenditure to a higher plateau. Once we have bigger government, it is very difficult to shrink it as the difficulty currently faced by Greek government shows.

This is the issue that the Europeans are facing right now. If governments attempt to ‘stimulate’ their stagnant economies by spending big, their fiscal deficits will continue to grow, even to the point of no return. Consequently, the financial markets will lose faith in the governments’ debt because it will mean either (1) raising taxes, (2) default, (3) printing money, or (4) some combinations of the three. That’s their motivation for pledging to cut fiscal deficits in the recent G20 Summit.

But the problem is, if they cut their fiscal deficits (i.e. cut spending), their economies as measured by the GDP will shrink. Not only that, a shrinking economy implies a shrinking tax receipts for the governments, which in turn implies that they will have greater difficulty trying to repay existing debts. When that becomes obvious, you will see the bond and stock market reacting very negatively.

But for the Americans, since their government bonds are not yet under attack (given that among other reasons, the USD is still the world reserve currency), their more immediate problem is domestic growth. In fact, demand for American government bonds increased as a result of the flight to ‘safety.’ Hence, Obama was on record to urge the Europeans not to kill growth by shrinking government spending. But as Niall Ferguson said, at this current trajectory, the US will be like Greece in several years time.

So, who is right? The Americans or the Europeans?

Obama could urge for a policy of continued government spending because time is more on America’s side. The financial wolf packs are currently busy with Europe. So, Obama must be thinking that if America can try another shot at ‘stimulating’ their economy, maybe in due time, the government can then let the private sector take over. That will be the time to reduce the US government’s fiscal deficits. Hopefully, that can be done before the financial wolf packs set their sights on America.

Using an analogy, the current situation is like Europe being pressured on two fronts simultaneously with no room to move. America, on the other hand, is facing pressure only on one front. Obama’s plan is to send troops to that front, deliver the knock-out blow before sending troops to face off the looming second front. The plan will fail spectacularly if the enemy arrives on the second front before the knock-out blow on the first front can be concluded.

So, place your bet on whether you think America’s plan will succeed. If you think they can pull it off (i.e. honour their debts), then buy US Treasuries (American government debt). If not, get physical gold.

How to buy and invest in physical gold and silver bullion

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  • Dan

    I will go for gold! I can't understand why would anyone be dumb enough to lend money to the us govt.

  • DavidL

    Considering the amount of deflation we are facing (look at M3 in the US or rather Shadow Stats estimate of M3) and it is obvious that governments could print trillions of dollars without creating inflation (defined as increase in prices or defined as increase in money supply, because money supply includes credit, which is disappearing faster than QE has been able to replace it). Some estimates put the amount the US could print at 25 Trillion just to balance the loss of money in the Shadow Banking System. This might be one time where you can have your cake and eat it too: print and spend instead of borrow and spend, take care of deflation at the same time you take care of the safety net and invest in the infrastructure of the future (alt energy, alt transport, and whatever else is really sustainable). Their are of course some real problems with doing this–and by real I mean both the limited resources of the earth which I think we are up against, and the reaction that classical economists would have with this idea. Of course there would be winners and losers doing this and the entrenched interests that really run the US Government would rather get the Shadow Banking System working again, as they own that, rather than eliminate that system and do something that might benefit other people…. That's my contrariwise take to the choice today's post proposes. Inflation is what makes the debt based fiat system work, getting rid of the shadow banking system would put central banks back in control of the financial system again. Spending 25 trillion could do a lot to put the US on a sustainable path–if it could be spent the right way. Not sure it would be good for gold (especially if this plan worked in a democratic way) and not sure it would be good for US Treasuries as there would be more money but not more debt in the system. Just my 2 cents (which would have been a dollar a hundred years ago….)

  • Troubled

    During the previous 20-30, the developed nations have been through a “golden” economic period.

    Benign economic conditions (financed by creation of debt) has fooled most people into believing in the current economic model.

    If developed nations debt could only balloon during this period, once governments attempt to join the private sector in deleveraging, I personally believe the outcome will get very ugly.

    We have already seen in the States when “stimulus” packages cease (cash-for-clunkers, housing tax credits) the respective markets resume their downward tragectory – which supports the “crutch” versus “stimulus” argument.

  • Pete


  • Pete

    I partially agree, but I think you are only looking at the first part of the process.

    If deflation occurs due to deleveraging, when a country is finally deleveraged and starts leveraging again, they will be leveraging off a much higher base. This means mega inflation.

    (Of course this is assuming that printed money goes into the spaces that debt used to fill…which won't happen in our imperfect world).

    For example, lets say an average house price is $200K, with an average $100K debt. Due to deflation, the price of the average house starts to fall. However, due to pumping printed money into the economy to replace the debt (increasing wages or however they plan to filter it to the public), house prices stop falling and are maintained at a level, not by borrowed money but by printed money. So now the average house is still $200K, but has very little debt financing it. The banks start to gain confidence and start lending again. Where can house prices go from here? Down? Well, the leverage from this base will make even more money available for the average person, for the average house. Inflation again, just from a higher currency base.

    Okay that was probably a bad example, and I probably shouldn't have brought property into this. But my point is that leverage/debt IS a form of currency inflation. If the debt disappears, we get deflation. If money printing replaces the debt, then we are back to the same size monetary base as when we had the debt, except that this time we don't. Then when debt starts to grow again we get inflation from debt that starts from a higher base.

    My overall point being that deflation will be a factor first, and money printing to combat that will at first appear to not be inflationary until an economic recovery starts and banks start lending again…at which time things will get crazy inflationary. Also there is the argument that the money printers will not know when to stop. Inflation is not instantaneous – by the time they see the signs it will probably be far too late to just stop money printing.

    Oh for a simple analogy! 🙂

  • Pete

    I asked CIJ to clarify my understanding of this a few months back and also sent him rough diagram I made regarding it. If you want a copy CIJ might still have it.

    …but i'm certainly no expert on this idea, it is just how I have understood others explaining it.

  • Pete

    Great post

  • Someone asked Marc Faber about how inflation can be possible when inflation is just “pushing on a shoe-string.” His reply was that,

    If I give you $1 million, are you going save all of it or are will you spend some of it? Also, even if you use it to repay all of your debt, it will wipe out debt servicing burden, which means you will spend in the future.

  • JL

    The political elites throughout the world, regardless of idealogy, are trying to keep the status quo.