AUSTERITY DOESN’T SHRINK THE DEFICIT IN A BALANCE SHEET RECESSION…

Despite the continuing woes in Europe there are still people out there who think the USA should cut off its arm in order lose weight.  Well, that’s not quite how it works during a balance sheet recession.  During a balance sheet recession the reduction in private sector aggregate demand leaves a hole in the economy.  As we know from the sectoral balances, someone must spend because the private sector’s savings (which they now demand due to high debt levels) must come from the foreign sector or the government sector.  It doesn’t just magically appear out of nowhere.  And if the government folds up shop we get what is happening in Greece.  The latest news shows that austerity is failing miserably (via the WSJ):

“BRUSSELS—Greece’s budget deficit in 2010 was 10.5% of gross domestic product, significantly larger than forecast by either the Greek government or European Union authorities, Eurostat, the EU’s official statistics agency, said Tuesday.

Lower-than-expected government revenue was the main culprit behind the higher deficit number. Greece has struggled to meet its goals for tax revenue under the rescue program overseen by the EU and the International Monetary Fund since last May. Economic growth has fallen short of forecasts, while the government has faced problems cracking down on tax evasion.

Greek government bonds continued to come under growing pressure Tuesday, when bonds yields soared alongside the rising cost of insuring Greek debt against default with credit default swaps.

The Greek government was targeting a 2010 deficit of 9.4% of GDP, although the European Commission in February said it expected the deficit to be 9.6% of GDP.

The missed target was “mainly the result of the deeper-than-anticipated recession of the Greek economy that affected tax revenue and social security contributions,” the Greek government said in a statement after the Eurostat announcement.”

I know these are dangerous words, but it really is different this time.  This is a highly unusual recession and the majority of the western world remains mired in it. In Greece, the private sector remains in a deep hole and aggregate demand has declined enormously.  When the government stopped spending they cut off one of the few private sector revenue sources that remained healthy.  This further reduced aggregate demand and is now resulting in even lower tax revenues.  The result is deeper recession, lower GDP and collapsing tax revenues.  You can see how this is problematic for a country.   The fact that they are a currency user (and not an issuer) makes matters even worse as Germany continues to step on the throat of the foreign sector due to the inability to devalue the Greek currency.

If my estimates are correct we can expect the USA to remain in the balance sheet recession until 2013 or longer.  Thus far, the USA appears relatively healthy because the government has been vigilant about filling in the spending gap via high deficits.  But make no mistake – the lingering credit problems that built up over the last 20 years are still underneath the surface wreaking havoc. Unfortunately, we have a Federal Reserve that is persistent in trying to make this private sector debt problem worse.  In many ways, they are countering the positive effects of fiscal policy by promoting further debt, inducing moral hazard and causing market based speculation that leads to imbalances.

The obvious counterargument is that cuts in spending will result in pain, but lay the foundation for even greater growth in the years ahead.  Well, that’s what Ireland said over three years ago when they diverged from the consensus and went into Austeria on their own.  The results speak for themselves.  If you don’t trust me you might try moving your family to Ireland.  Let us know how you feel after 6 months when you can’t find a job or feed your family. It’s not a pretty picture over there and they’re quickly realizing that austerity hasn’t resulted in quick cuts and rapid growth.

The spending by this government has been very poorly allocated, however, it remains enough for a meager growth environment.  In a balance sheet recession the downside risk is a long drawn out Japan style economic environment.  We’ve already had one lost decade in this country.  There’s no need for another.  The USA is not bankrupt. We can always afford to spend in the currency that we alone create.  Default is an impossibility for a nation that has no foreign denominated debt and is the currency issuer in a floating exchange rate system.  Our only form of default would come in the form of hyperinflation.  And with 2.7% inflation I think we are still far from having to worry about hyperinflation.