Which Is Better - Stimulus or Austerity?

Here's an interesting article comparing the ongoing responses to the fiscal crisis that started in 2008 - both the European response and the American response.  The American response has primarily been one of stimulus - the government is taking on additional debt to provide a stimulus to the public sector.  Conversely, the European response has primarily been one of austerity - cutting government workers and programs and raising taxes.  Let's take a look at the likely outcomes of these policies - and how these may impact your investments in the future.



As an initial matter, let's define what we want.  We want a country that experiences economic growth on a consistent basis - of at least 2%/year GDP growth.  One reason that we want this is so that the economy will continue to create jobs for those entering the work force.  Another thing that we want is inflation at a rate of 2-3%/year - and we certainly don't want deflation.  With inflation at 2-3%, we are basically forcing people to invest money in order to maintain the value of that money over time - which in turn drives our economic development - your dollar will be worth a lesser amount next year, so you better invest so that you have $1.03 by next year.  In contrast, with deflation dollars are worth more the longer you wait - which makes people put off expenditures - which in turn means that companies can't sell anything because people are not buying - which means that the companies begin laying people off.  Generally, deflation creates a negative spiral that is hard to recover from and should be avoided with all reasonable effort.

First, the American response of stimulus is based on Keynesian economics which postulates that we can use government stimulus to raise the level of economic activity to soften an economic slowdown - thus avoiding a potential deflation of the currency.  Frankly, this appears to be working in general.  It is certainly the case that the stimulus could have been more directly injected into the US economy if the purchasing power of the stimulus was constrained to purchase goods from American manufacturers - or American services.  For example, if stimulus money goes to purchase a Chinese-made TV, then the stimulus is not helping the American economy - it's helping the Chinese economy.  Frankly, the way we did the stimulus was kind of sloppy, but it seems to have worked to an extent.

However, the cost of the stimulus is a massive increase in national debt - which typically drives down the value of a currency - and has done so for the US dollar.  This in turn helps make the prices of our goods more attractive in foreign countries.  Unfortunately, the national debt will need to be paid off.  Keynes' idea is that the government should have the discipline to pay down the debt once economic growth has recovered.  By paying down the debt, our currency rises and our goods become more expensive, thus slowing down economic growth to prevent another bubble. 

So in one real sense, the US is in the "good part" of this boom/bust cycle.  Our economic growth is being artificially inflated now, but will need to be artificially deflated later by debt repayment.  Failure to repay the debt will put the US in a much more vulnerable economic position during the next cycle.  Further, even if our stimulus/repayment model works, we can see by the amount of debt that we have accumulated that American economic growth is going to be greatly restrained by debt payback (and the additional taxes and increase in currency valuation associated with it) until at least 2017 - and maybe until 2020.  It's probably not going to get much worse, but the upside potential is going to be constrained for most of the next decade.

On the other hand, let's consider the European response of austerity.  I agree with the author of the article that the European response is pretty old school - it does not take into account the realities of cross-border trade, the impact of increased taxes and reduced government spending on economic growth, and the problems with the Euro as a multi-national currency.  That is, consider what happens to an economy when the largest employer goes away - many people lose their jobs - which in turn causes a decline in economic activity because those people can't buy anything - which in turn causes the companies to lay off more people.  Additionally, you will see an increase in the foreclosure rate due to job loss - which will make it more difficult to get lenders to put up money to build additional houses, further decreasing the economic condition.

However, once the economy reaches a stable point, they will not be saddled with the long-term drag on economic growth that the US will have for several years thereafter as it works to repay the debt due to the stimulus.  Consequently, once Europe reaches the bottom, Europe is going to be a good place to invest (compared to the US) and will likely outperform the US for several years thereafter.

However, Europe still has the problem of the multi-national Euro - which is actually kind of a big problem.  Normally, when a country's economic growth declines, their currency will also decline - which will then make their exports relatively less expensive, which in turn helps their economic growth recover.  However, weaker European countries that use the Euro (like Greece) won't be able to take advantage of this effect because the currency that they employ will not be able to decrease to a level reflecting their new economic reality because the Euro's value is held up by stronger countries like Germany. 

In reality, one of the best things for Greece right now would be to get dumped from the Euro.  An individual Greek currency that is not coupled to the Euro would allow Greece to recover much faster - same for Ireland.  Frankly, without the stimulative effect of a reduction in currency value, I seriously question whether Greece can recover in a decade.  Further, the failure of Greece to recover will be a drag on the Euro's value - which would serve to act in apposite to the likely project growth of Europe as a whole.

So which is better, stimulus or austerity?  For the US, the answer is pretty clear - a period of stimulus (preferably more targeted to US economic activity) followed by a pay-back period with regard to the debt looks like it will smooth the economic turmoil and produce the fewest negative impacts.  Conversely, implementing austerity by greatly cutting government spending and increasing taxes appears that it might create the dreaded deflationary spiral.  Small cuts and small tax raises are probably OK, especially governmental cuts to purchases of materials from non-US manufacturers or service providers. 

On the other hand, instead of spreading out the pain over a decade, austerity seeks to take all the pain right up front so that the economy can get to it's new level as soon as possible.  That can be traumatic, but once the economy is at the new level, it's going to go up faster in general.  The catch here is the drag on growth produced by underperforming Euro countries like Greece.

In general, for the citizens of a country - stimulus appears better than austerity in the short and medium term.  For investors, the US is likely to be a better country to invest in for at least the next year to 18 months.  In Europe, I would expect further turmoil and a bitter spiral wherein austerity produces economic decline - which in turn produce more austerity in Europe.  I would not be surprised to see other countries like Portugal get impacted.  However, I would recommend re-evaluating the European situation every 6 months or so to look for a stabilization at the bottom.  Once it happens, Europe is likely to outperform the US for years afterwards - especially if Greece gets dumped from the Euro. 

What's your take?