What seems clear by this point is that anyone who naively assumes the US economy can cut its way to the promised land — simply slash spending to reduce the deficit and reduce “uncertainty” — is mistaken.
The experience in Europe show that austerity is no panacea–not because economies are contracting, but because deficits aren’t even shrinking, in many cases.
And the IMF has issued a new report warning about the challenges to developed countries when governments contract.
Ambrose Evans-Pritchard discusses it:
Normally, tightening of 1pc of GDP in one country leads to a 0.5pc loss of growth after two years. It is another story when half the globe is in trouble and tightening in lockstep. Lost growth would be double if interest rates are already zero, and if everybody cuts spending at once.
“Not all countries can reduce the value of their currency and increase net exports at the same time,” it said. Nobel economist Joe Stiglitz goes further, warning that dam may break altogether in parts of Europe, setting off a “death spiral”.
The Fund said damage also doubles for states that cannot cut rates or devalue – think Spain, Portugal, Ireland, Greece, and Italy, all trapped in EMU at overvalued exchange rates.
These charts with the report (.pdf) offer the top level view.
Here are all the contractions that were studies, and how they were achieved:
And here’s the range of possible effects: