Pondering Austerity In The Months Ahead

There are more green shoots in the economy these days, but there are more risks as well. The question is whether the risks have enough momentum to overwhelm the positives? No one really knows the answer, of course, but it’s clear that the stakes are higher than just a month or two ago.

Even the more optimistic scenarios have been precarious, largely because the blowback from the massive debts left over from the boom weigh heavily on the U.S. economy. That’s been there all along, of course, but the case has been strengthening for thinking that the forces of growth had the upper hand, albeit marginally so. But the upheaval in the Middle East, transmitted through higher oil prices, is a new hazard to consider.
There’s also the unknown variable of pressing austerity in Washington. No one doubts that imposing fiscal rectitude is a net plus for the years and decades ahead. There’s too much red ink for comfort these days. The unknown is how, or whether, taking steps to reverse the deficit casts a shadow for the macro outlook in the months ahead. More specifically, will the political push to cut government spending now nip the precarious economic revival 2.0 in the bud? There’s a fair amount of mystery here since the political outcome is, as yet, unknown and the situation, as they say, remains fluid.
The Democratic-controlled U.S. Senate, yesterday, said nay to the Republican plan to trim $61 billion from the federal budget. What happens next is anyone’s guess. Will the cuts end up rising, or falling? Meantime, there are two schools of thought on whether cutting more will help or hinder the near-term outlook. We know what awaits in the long run, but it’s the year ahead that comes first. Navigating this fine line isn’t going to be easy.
In a prepared statement delivered to Congress on Tuesday, Erskine Bowles and Alan Simpson of the President’s Commission on Fiscal Responsibility and Reform warned:

If the U.S. does not put its fiscal house in order, the reckoning will be sure and the devastation severe. We believe that if we do not take decisive action our nation faces the most predictable economic crisis in its history. The current fiscal path we are on is simply not sustainable. Spending is rising rapidly, and revenues are failing to keep pace. As a result, the federal government is forced to borrow huge sums each year to make up the difference. In bad economic times, such borrowing might make sense in order to soften the blow of a recession. Our concern is not so much the record deficits we face today, although they do cause us real worry. Our principle concerns are the prospects that borrowing will remain high throughout the decade, and rise substantially as time goes on. Under a reasonable set of assumptions, our national debt will surpass 90 percent of Gross Domestic Project (GDP) by the end of the decade, a level not seen since just after World War II, and a level most economists find problematic.

The power of such thinking is only strengthened by the message in history, as shown in the must-read book This Time Is Different: Eight Centuries of Financial Folly. For hundreds of years, nations continue to defy the law of fiscal gravity and continue to pay a heavy price. In the long run, there’s little doubt how this story ends.
But the details of navigating a precarious recovery in the here and now are no small complication. It’s unclear how high oil prices can go before derailing the rebound. But with prices trending higher, the wiggle room is clearly shrinking.
Meanwhile, what of the countries that are aggressively pursuing austerity? Is that helping in the short run? As usual, real time debate falls well short of a consensus. There’s evidence that the UK’s recent embrace of budget slashing is helping the bond market and arguably averted a debt crisis. Meanwhile, forecasters are cutting estimates for growth in the British economy.
Deciding if fiscal austerity will help, or hinder, the near-term U.S. outlook depends on several factors, starting with the path of oil prices over the next 6 to 12 months. Austerity with oil at $150 a barrel is quite a different animal vs. $90 a barrel. Unfortunately, predicting how the turmoil in Libya plays out, and whether that spreads to other large crude exporters, is a mug’s game.
What’s obvious is that higher oil prices create hazards for growth. Until (or if) oil prices settle down, the details on budget cutting remain unstable. That raises the question anew: Can budget cuts spawn growth?