Fiscal Austerity May Not Work


Washington’s Blog
May 27, 2010

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Chief investment officer of PIMCO Bill Gross says that austerity may not work to lower sovereign debt.

Bill Gross manages the world’s largest bond fund (Pimco: managing more than a Trillion Dollars).

As such, he has to be considered one of the world’s top bond vigilantes.

But Gross says in his latest investment outlook that austerity may not work to lower sovereign debt:

Granted, sovereign debtor nations are now saying all the right things and in some cases enacting legislation that promises to halt growing debt burdens. Not only Greece and the southern European peripherals, but France, the U.K., Japan, and even the U.S. are sounding alarms that might eventually move them towards less imbalanced budgets and lower deficits as a percentage of GDP.

Still, credit and equity market vigilantes are wondering if in many cases sovereigns haven’t already gone too far and that the only way out might be via default or the more politely used phrase of “restructuring.” At the now restrictive yields of LIBOR+ 300-350 basis points being imposed by the EU and the IMF alike, there is no reasonable scenario which would allow Greece to “grow” its way out of its sixteen tons. Fiscal tightening, while conservative in intent, leads to lower and lower growth in the short run.

Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator. In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits!

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In other words, when a highly-indebted nation implements fiscal austerity and slashes spending, it can increase unemployment and slow spending, deepen the country’s recession, and thus cause creditors may look at the country’s economy as more risky, thus requiring more of a risk premium, so that the cost of funding it’s debt increases.

As Joe Weisenthal notes:

This isn’t just a theoretical point. Countries have already experience this (see: Ireland).

And we’re back left wondering whether anyone has any understanding of sovereign debt.

Ireland cuts its spending, and its debt problem gets worse.

If austerity isn’t the answer, and given that massive new borrowing at high interest rates isn’t the answer? what should countries experiencing a sovereign debt crisis do?

For starters, the ability to create credit to loan to the beleaguered countries should be taken away from private banks which charge huge fees to their own governments for doing something which every sovereign nation has the inherent power to do itself.


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