More evidence against the "austerians"

The recent G-20 summit at Toronto was the clearest signal that collectively the leaders of the major economies had, in the face of rising deficits and debts, decided to move away from any further stimuluses and embrace debt reduction. The leaders pledged "at least" to halve their deficits by 2013. With an estimated collective fiscal adjustment worth around 1% of its combined GDP next year, the Economist decribes it the "biggest synchronised budget contraction in at least four decades".

Notwithstanding this turn into the path of fiscal contraction, the case against fiscal austerity gets stronger with every passing day, atleast for the US. This is especially so given the present macroeconomic environment where austerity could not only tip the economy back into recession and further increase unemployment but also lower tax revenues and worsen the medium-term budget balance.

Faced with the zero-bound, the monetary policy has lost all traction, and efforts to lower long-term rates and reduce the cost of private debt are not likely to yield much without an unacceptably (politically) massive expansion of the Fed's balance sheet.

The San Francisco Fed has this graphic of increasing vaccancies in office, retail, and industrial spaces across the US, a reflection of the weak demand for business investments.



Paul Krugman points to the lock-step nature of co-movement between the US non-residential fixed investment spending (or business investment, as a percentage of GDP) and the US output gap (the percentage difference between real GDP and the CBO’s estimate of potential real GDP) over the past two decades, to argue that business investment should, if anything, be even lower.





Austerians attribute the weak business investment environment to the lack of confidence about economic prospects and aggregate demand due to the massive deficits and debt stocks (that would presumably force people into cutting down on spending in anticipation of higher taxes in future).

The central thrust of the austerians' arguement have been that the massive expansion of the monetary base will unhinge inflationary expectations and the rising deficits and debt stocks (which in turn is attributed to the stimulus spending) will put upward pressure on interest rates besides crowding out private investment. They also argue that since the stimulus spending has contributed to the deficits, phasing it out will reduce the debt stock.

However, these fears are not borne out by any market indicators. Far from the illusory bond market vigilantes driving up the yields, the rates on long-term T-Bonds remain low and have been on a southward trend.

Menzie Chinn points to a series of indicators - annualized 3 month change in price indices, 10 and 1 year inflation expectations, 10 year Treasury-TIPS and 5 year-TIPS spreads, and money supply - and finds no signs of any inflation surge.



Instead, there are ample signs that deflation should be the immediate concern for policy makers across much of the developed world. Deflation would raise real interest rates, exacerbate the debt problems, and push the can further down the recovery path. John Makin of the American Enterprise Institute has warned that the United States and Europe are heading toward "deflation, a classic prolonger of crises that boosts the real burden of debt and crushes profit margins". Paul Krugman uses monthly inflation data to point out that the US economy may already be in the deflation territory. Mike Bryan from the Atlanta Fed too thinks that the US economy may be much closer to deflation than is widely perceived.

Update 1 (15/7/2010)
David Beckworth points to Rebecca Wider's article about inflation expectations falling globally. She has this chart which illustrates the 10-yr break-even expected inflation rates for the UK, Germany, Canada, Italy, and the US using their respective inflation-indexed bond markets (TIPS in the US).



Update 2 (16/7/2010)
Superb explanation by Mark Thoma of why the massive expansion in monetary base has not generated inflation and instead deflation may be on the horizon. Boston Fed’s Rosengren too feels deflation is an emerging risk.

Update 3 (17/7/2010)
In June, the headline figure on consumer prices fell slightly while the core number rose slightly. Here's the 12-month percentage change in core inflation.



Update 4 (18/7/2010)

Paul Krugman points to the steeply falling 10 year TIPS spreads (difference between the interest rate on ordinary government bonds and bonds indexed to inflation). Also the Cleveland Fed too points to declining inflation expectations.



Update 5 (27/7/2010)
Brad DeLong looks at the numbers and writes,

"The Administration's mid-session review - released last week - projects that the unemployment rate will rise in the next several months and will be at 9.3% in February 2011. It projects that Q4/Q4 real GDP growth will be 2.9% this year - and I don't see how we are going to get there with a 2.7% growth rate in the first quarter, a likely 2.0% growth rate in the second quarter, and with the tracking third-quarter growth at at 2.9%. We would need 4.0% growth in the fourth quarter of this year. Nor do I understand where the 1.7% decline in unemployment over 2011 is supposed to come from: a simple Okun's Law coefficient of 2 would suggest that we need 2 x 1.7 + 2.6 = 6% real GDP growth to generate such a decline.

According to Mark Zandi, in the fourth quarter of this year the phase-out of the ARRA is likely to shave 0.3% off the real GDP growth rate. in 2011, the contractionary effects of the ARRA phase-out on the quarterly growth rates are likely to be -0.8%, -1.2%, -0.7%, and -0.2%."