Austerity Offers Europe their Only Hope

By: Michael Pento | Wed, May 16, 2012
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The prevailing view amongst Keynesians is that the austerity measures being taken in Europe to prevent a complete currency and bond market collapse is the cause of their current recession. But blaming a recession on the idea that an insolvent government was finally forced into reducing its debt is like blaming a morning hangover on the fact that you eventually had to stop drinking the night before.

There is now a huge debate over whether the developed world's sovereigns should embrace austerity or increase government spending in an effort to boost demand and avoid a full-blown economic meltdown. Former U.S. Secretary of Labor and current professor of public policy at the University of California, Robert Reich, recently wrote a commentary titled, "We Should Not Imitate the Austerity of Europe." In it, Mr. Reich contends we should simply; "Blame [the recession] on austerity economics -- the bizarre view that economic slowdowns result from excessive debt, so government should cut spending" He continued, "A large debt with faster growth is preferable to a smaller debt sitting atop no growth at all. And it's infinitely better than a smaller debt on top of a contracting economy."

But Mr. Reich and those like him who vilify austerity measures are ignoring the reality that investors in periphery European sovereign debt had already declared those markets to be insolvent. Sharply rising bond yields in southern Europe and Ireland were a clear signal that their debt to GDP ratios had eclipsed the level in which investors believed the tax base could support the debt. Once sovereign debt has risen to a level that it cannot be paid back, by definition, the country must default through hyperinflation or restructuring.

However, in the unlikely scenario that the bond market actually has it wrong, a dramatic reduction in government spending gives sovereigns their only fighting chance before admitting defeat and pursuing one of the two default strategies.

If these governments can quickly balance their budgets and lower the level of nominal debt outstanding; it gives them a chance to restore investors' confidence in the bond market, bolsters confidence in holding the Euro and offers the hope that the private sector can rapidly supplant the erstwhile reliance on public sector spending.

Keynesians must realize that it was the high level of government spending supported by a compliant central bank that initially caused the debt to GDP ratios to skyrocket to the point where governments are now deemed to be insolvent.

These governments already tried over borrowing and spending and it didn't work. How is it possible to believe that adding even more public sector debt, most of which is printed, can fix the problem? Public sector spending doesn't grow an economy; it just adds to the debt and thus, increases the debt to GDP ratio. Yet more government spending, or investment as they like to call it, guarantees the bond market will be correct in judging Europe sovereigns bankrupt. Additional public borrowing not only increases debt but steals more money from the private sector that would otherwise be used to pare down onerous household debt levels or invest in the private sector--the only viable part of the economy that can support growth. It would also cause the ECB to print more money and create more inflation; resulting in a further reduction of economic growth and the standard of living.

The sad truth is that austerity is coming to Europe regardless of whether it is voluntary, or because the international bond market forces it upon them. Pursuing voluntary austerity measures gives Europe, and indeed the developed world, there only chance before defaulting on the debt. Indeed, Japan and the U.S. now have a better opportunity than Europe to make austerity measures work. That's because both their bond markets are currently quiescent; despite that fact that both of their debt to GDP ratios are far worse than in the Eurozone--EU (17) debt to GDP is 87%, while the U.S. has 103% and Japan has 230% public debt to GDP ratio. But the bottom line is that austerity is the market-based mechanism to countervail decades of profligate government profligacy.

Forcing down a few more drinks to delay a hangover isn't a very good strategy. Mr. Reich and the rest of the Keynesians should acknowledge that it is impossible for individuals, or a nation, to stay drunk forever.

 


 

Michael Pento

Author: Michael Pento

Michael Pento, President
Pento Portfolio Strategies

Michael Pento

Michael Pento is the President and Founder of Pento Portfolio Strategies (PPS) and author of the book "The Coming Bond Market Collapse." PPS is a Registered Investment Advisory Firm that provides money management services and research for individual and institutional clients.

Michael is a well-established specialist in markets and economics and a regular guest on CNBC, CNN, Bloomberg, FOX Business News and other international media outlets. His market analysis can also be read in most major financial publications, including the Wall Street Journal. He also acts as a Financial Columnist for Forbes, Contributor to thestreet.com and is a blogger at the Huffington Post.

Prior to starting PPS, Michael served as a senior economist and vice president of the managed products division of Euro Pacific Capital. There, he also led an external sales division that marketed their managed products to outside broker-dealers and registered investment advisors.

Additionally, Michael has worked at an investment advisory firm where he helped create ETFs and UITs that were sold throughout Wall Street. Earlier in his career he spent two years on the floor of the New York Stock Exchange. He has carried series 7, 63, 65, 55 and Life and Health Insurance Licenses. Michael Pento graduated from Rowan University in 1991.

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