Why the economists who think we can cut our way to recovery got it all wrong:
Credit bubbles produce the exact opposite of productive resources. Deleveragers — those folks formerly known as consumers — spend the next decade paying down these obligations, rather than buying additional goods and services. And heavily indebted state and local governments are similarly thrifty, adding further pressure to the post-crisis economy.
Confusion about this is already taking a toll across the pond. The Irish, British and, soon, Greeks have bought into a misguided belief in austerity — that they can somehow cut their way to growth. In the United States, we have seen states and municipalities slashing head counts of teachers, cops and firemen. The “paradox of thrift” has morphed into a misguided economics of austerity. Hence, even when the private sector manages to create some jobs, it’s offset by public-sector job cuts.
In the not too distant past, the market might have been inclined to rally following a horrific data point such as June’s NFP report. The assumption was that the Fed, or perhaps Congress, would respond to economic distress with its usual largess. But the immediate market reaction — selling off on the “surprisingly” bad number, and then having difficulty all last week — suggests that traders are no longer expecting a cavalry charge to save the day.
Indeed, the Federal Reserve is in no position to do much more without great distress. Markets briefly rallied Wednesday when Fed chief Ben Bernanke suggested that a QE3 was possible. But soon after he finished his congressional testimony, Federal Reserve Bank of Dallas President (and FOMC voting member) Richard Fisher said the Fed had “exhausted our ammunition.” And Thursday, Bernanke scared markets further, saying the central bank wasn’t yet ready to take additional steps to boost the economy.
Markets gave up most of their rally on the recognition that the cavalry might not come this time.
Even with the Fed out of the picture, investors should not expect any relief from Congress: The legislative body in charge of taxing and spending seems incapable of accomplishing much these days. We are more likely to see counterproductive austerity measures than anything else.