By this point, not even David Rosenberg believes that budget cutting is the path to prosperity.
His evidence: Only every time it’s been tried so far in Europe with no positive effect on either GDP or the deficit.
ZeroHedge, which notes “worrisome” traces of Krugman in Rosenberg’s new thinking, has yesterday’s note, in which he calls Irish budget cutting insane.
We’ll be shocked if Rosenberg doesn’t catch hell from his loyal readers for this. Remember when Ambrose Evans-Pritchard dared to veer towards Keynes? It wasn’t pretty.
Yesterday’s very weak U.S. new home sales data underscore the mixed nature of the other data releases. That said, Q4 real GDP in the U.S. is now likely to come in a tad better than I expected. While the U.S. consumer seems to have some legs as year-end approaches, my worry list for 2011 has not changed. Next year, even assuming the Bush tax cuts are extended, fiscal policy at the federal level will withdraw five-tenths of a percentage point from real GDP, at the least. Furthermore, closing the massive budget gaps at the state and local level will withdraw a further 1.5 percentage points from GDP. Again, this is a conservative estimate but a total of two-percentage points of fiscal drainage with questionable offsets from the other sectors of the economy.
Then, of course, in Europe, there is fiscal tightening and rising risk premia associated with potential sovereign defaults. Those developments will have a negative impact on exports too. Also, the response to exchange rate manipulation in Asia could well draw higher tariffs, and the resulting trade war would impact asset prices and the economic outlook that much further.
I think the dramatic fiscal tightening we are seeing in Ireland and others is insane and I wonder how a new government in early 2011 is going to react. Spanish bond spreads are behaving like Ireland did precisely six-months ago when Greece was getting bailed out (it’s not really a bailout — the stringent strings attached are like a hangman’s rope).
Everybody seems to believe the euro is sacrosanct but this was also the view around the Argentina currency board nearly a decade ago, the country ultimately devalued in order to reflate its economy and pay off its debts in debased currency. After the 10-year currency convertibility plan was abandoned in early 2002, the Argentinean peso depreciated 80%, which in turn paved the way for massive trade surpluses, and from 2003 to 2007, real GDP expanded at a 9% annual rate, and real wages rose by nearly 5% per year. Growth ensued. Memories faded.
Sweden, in the early 90s, is another example, and the reason Iceland no longer makes the news is because the krona has been devalued 60%.
The end-game as I see it is that some of these peripheral EMU countries leave the union, go back to their own currency so they can reclaim control over their monetary policy and pay their debts in devalued punts, drachmas and pesetas. These peripheral EMU countries need to reflate but are being forced to do the exact opposite by being linked to a currency union. Other countries, such as Germany and the UK, that have big banks that own a ton of these peripheral European bonds will simply see their governments issue debt to cover the losses, either in part or whole (Merkel will see to it that in Germany’s case, it will be the former) in their financial sector. We’ll look back at this like we did Argentina and Russia … with faded memories.
But if it plays out like this, it would be a devastating deflationary shock for the global economy, for at least a few months. And, U.S. companies would likely confront a huge appreciation in the dollar, which would cut into their foreign-derived earnings base. Commodity prices would undoubtedly correct and safe-haven flows would certainly redress the loonie’s overvaluation gap. Treasuries would rally big-time.
I’d welcome any responses/views to this thesis. Call it scenario building, but our pro-CAD and pro-commodity views are at stake. Gold would remain bid — yesterday’s rally in the face of the USD rally is a case in point.
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