When the housing bubble burst in 2006, U.S. policy makers looked to Japan for clues about what to do -- and not do -- in response. Now their attention is shifting to Europe as America gets set to follow that region with a concerted attack on its budget deficit.
Among the lessons being drawn: Don’t put off budget action until the financial markets demand it. Big, immediate cuts aren’t always the best way to reduce deficits. And central bankers should be ready to try to offset the economic impact of any fiscal contraction.
“The lesson of Europe is, don’t wait until you’re in a crisis to act. Do it now,” said Alice Rivlin, the founding director of the Congressional Budget Office in Washington. “The other lesson is that austerity is not a good prescription for weak economies.”
The stock market would benefit if the U.S. avoids the year- end so-called fiscal cliff and reaches a deal to put the deficit on a downward path, said Jack Ablin, who helps oversee about $65 billion of assets as chief investment officer at BMO Private Bank in Chicago.
“A credible plan would build confidence among investors,” he said.
David Cote, chairman and chief executive officer of Morris Township, New Jersey-based Honeywell International Inc. (HON:US), agreed. Should lawmakers be able to sketch out an agreement by the start of 2013 to cut the deficit by $4 trillion over 10 years, then “you end up with markets looking at that and going, ‘Oh my God, these guys can govern,' '' he said in an Oct. 25 interview with Bloomberg Television.
Stock prices slumped last week partly on concern that Congress will allow about $607 billion in automatic spending cuts and tax increases to go ahead next year. The Standard & Poor’s 500 Index (SPX) ended at 1,379.85 on Nov. 9, down 2.4 percent on the week.
“This would be self-inflicted, disorderly contraction that would unambiguously push our country into recession,” Mohamed El-Erian, chief executive officer of Pacific Investment Management Co., which manages more than $1.9 trillion in assets, said in a phone interview.
Bond prices rallied on the recession concerns, pushing the yield on the 10-year Treasury note down to 1.61 percent at 5 p.m. on Nov. 9 in New York from 1.71 percent a week earlier.
Yields would reverse course if the fiscal cliff is averted, according to Credit Suisse Group AG analysts led by Carl Lantz in New York. They forecast in a Nov. 8 report that the 10-year yield will rise to 1.75 percent by year-end and to 2 percent in 2013 on a “pragmatic resolution” of the budget battle.
That’s still low by historic standards. Over the last 10 years, the 10-year yield has averaged 3.69 percent.
President Barack Obama put reducing the deficit at the top of the list of challenges he said he wants to tackle after winning election to another four-year term. He invited Congressional leaders last week to a White House meeting to discuss averting the automatic austerity measures.
“We have to combine spending cuts with revenue,” he said in remarks at the White House on Nov. 9.
The center of fiscal restraint is rotating toward the U.S. from Europe, analysts at Barclays Plc said in an Oct. 11 report. They predicted a 1.5 percent of gross domestic product change in the U.S.’s structural budget balance next year, up from a 1 percent swing this year, while the euro-area’s shift will fall to 1.2 percent from 1.4 percent.
Belt-tightening is “a big theme globally and there’s going to be more focus on the U.S., which, in terms of fiscal consolidation, has done very little,” said Laurent Fransolet, head of European interest-rate strategy at Barclays in London.
The U.S. has run deficits for 11 straight years, with a shortfall in excess of $1 trillion in each of the last four. That’s pushed publicly held debt as a percentage of GDP to 67 percent this year from 36 percent in 2007, according to data from the Office of Management and Budget. The deficit for the fiscal year that ended on Sept. 30 was equivalent to 7 percent of the economy.
Some euro-area nations have been forced into a swifter reckoning by investors pushing up the yields on their bonds, a problem the U.S. has so far not incurred. Yields on Greece’s security due in February 2023 reached a high of 31 percent on May 31.
They fell to about 18 percent last week after Greek lawmakers backed another round of austerity measures. The country will run a budget deficit of 5.5 percent of GDP in 2013 compared with 15.6 percent in 2009, according to the Brussels- based European Commission. Ireland’s shortfall will fall to 7.5 percent of GDP from a peak of 30.9 percent in 2010, when it was swelled by bank bailouts, and Portugal’s will be 4.5 percent from 10.2 percent in 2009, the commission said on Nov. 7.
The economies have paid a steep price. The commission predicts the Greek economy will shrink for a sixth straight year in 2013, contracting 4.2 percent after this year’s 6 percent slide. Unemployment is already more than 25 percent.
Portugal will lose 1 percent and Ireland will eke out growth of just 1.1 percent, the Commission said.
The experience of Europe’s peripheral countries shows that U.S. policy makers should tackle America’s swelling debt before investors force them to do so, said Mark Zandi, chief economist at Moody’s Analytics Inc. in West Chester, Pa.
“You don’t want to address these problems in the middle of a fiscal crisis because the costs will be enormous,” he said.
Unlike euro-area nations, Britain was not forced into action by rising bond yields when the government of Prime Minister David Cameron began its deficit-cutting drive in 2010. The U.K. did follow the same blueprint, frontloading tax and spending steps in the biggest fiscal squeeze since the aftermath of World War II.
The result: the economy double dipped into a recession from which it is just now recovering. The commission predicts GDP will grow 0.9 percent in 2013 after shrinking 0.3 percent this year.
“The Brits learned the hard way that you can do a lot of damage if you don’t phase in fiscal consolidation, especially when the economy is weak,” said Nariman Behravesh, chief economist for IHS Inc. in Lexington, Massachusetts.
An International Monetary Fund review of recent austerity measures in 28 countries from Italy to Japan found that the steps have had a bigger negative impact on their economies than traditional macroeconomic models, including the IMF’s own, had predicted.
With short-term interest rates already at or near zero percent, central banks have had less room to offset the economic impact of fiscal tightening, explained Jacob Kirkegaard, a research fellow at the Peterson Institute for International Economics in Washington.
Britain, though, has managed to emerge from its recession sooner than some of its euro-area counterparts because the Bank of England has used unorthodox monetary measures to pump up the economy, according to Behravesh.
The central bank said on Nov. 9 that it would transfer income from gilts it holds under its bond-buying program to the Treasury, a move that Governor Mervyn King suggested equated to an easing of monetary conditions.
The Federal Reserve also has ratcheted up its support for the economy with its September announcement of an open-ended program to buy $40 billion of mortgage-backed securities per month. This is the Fed’s third round of asset purchases after it cut its target interest rate to near zero in December 2007.
The European Central Bank has not been as aggressive as its U.S. and U.K. counterparts in easing monetary policy, reducing its key interest rate to a record low of 0.75 percent over a longer timeframe and rejecting quantitative easing. It has injected cash into markets and is now offering to buy bonds of governments that sign up to plans to modernize their economies.
In trying to cut debt as a share of the economy, policy makers need to focus on promoting growth as well as curbing deficits, said El-Erian at Newport Beach, California-based Pimco.
Failure to do so in Europe has often meant austerity ended up hurting the economy so much that it worked against debt reduction. Greece’s debt, for example, is now forecast by the commission to rise to 188.9 percent of GDP in 2014 from 176.7 percent this year. Under its second bailout agreement, debt was seen peaking at 167 percent of GDP in 2013.
“You’ve got to act on both the denominator and the numerator,” said El-Erian.
Treasury Secretary Timothy F. Geithner also has stressed the importance of spurring growth while taking steps to narrow budget deficits in the longer-run, in comments aimed at both the euro area and Congress.
Geithner was among those U.S. policy makers who looked to Japan for lessons when the financial crisis struck. He quickly sought to shore up U.S. banks, putting them though a stress test in 2009 and forcing them to raise capital afterwards -- in contrast to the protracted approach taken by Japan. Fed Chairman Ben S. Bernanke also acted more aggressively than the Bank of Japan when faced with the danger of deflation.
In discussing ways to reduce the government’s red ink, Geithner -- like his boss, Obama -- has advocated a balanced approach that combines higher taxes and lower spending. That’s the same strategy European nations have taken, Kirkegaard said.
Europe also shows the importance of coming up with a credible, long-run budget plan that the financial markets can believe in, he said. That’s not what Greece has been able to do and as a result, it’s been in a constant state of crisis.
“We have the luxury that the Europeans don’t,” said Rivlin, a senior fellow at the Brookings Institution in Washington. “We aren’t under pressure in the financial markets.
“That means we should put a plan in place now that acts gradually over time before we get into trouble.”
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