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June 2010 Market Commentary Amit Chokshi

Austerity Histrionics
Greek riots and troubling declines in the value of the Euro in recent months have sparked a global austerity push whereby
deficits, irrespective of their length, size, or cause, are deemed "bad". Consequently policymakers are ignoring the
biggest problem - unemployment - in favor of deficit reduction. Even worse, policymakers are failing to grasp that the
main cause of these grinding deficits has been one of the most severe, financially induced economic crises in history and
the recovery has been extremely tepid and fragile. Rather than focus on implementing growth policies, countries across
the globe are rushing to embrace fiscal austerity, imposing additional suffering on the majority of people and potentially
reversing economic gains.

What should be noted is that those clamoring for fiscal austerity - "Very Serious People" - were the same people that
failed to detect the multitrillion dollar housing bubble that played a major role in derailing the global economy. Take
Ireland for example. Ireland had maintained budget surpluses and also had low national debt levels prior to the implosion
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of the housing bubble . Those policymakers responsible for economic policies such as the European Central Bank
("ECB") missed the bubble and in some cases implemented policies that encouraged the bubble and yet surprisingly are
still in a position to prescribe economic remedies.

The biggest danger with a rush for austerity is that the ECB, International Monetary Fund ("IMF"), and other institutions
favoring deficit reduction are putting all of their chips behind a private sector recovery. The only reason to curtail
government expenses and raise taxes at this point is the belief that the private sector is healthy enough to pick up the
GDP drag that a reduction in government spending and tax increases will yield. This is a ridiculous belief given the
economic decline the world has experienced and continues to slough through.

The data has indicated the recovery has been pathetic. For example, US Q1 2010 GDP was reported to come in at an
annualized rate of 2.7%. In periods where GDP has fallen off in the high single digits as happened with the US, the
bounce back during the recovery period should be very high. However, policymakers have research that clearly shows
that financially induced economic crises have much more challenging and anemic recoveries. Despite the numerous
research on the aftermath of financially led collapses, policymakers have felt little need to change their playbook with
respect to getting the economy back on its feet. Under normal conditions, 2.7% is decent growth but coming out of a
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massive collapse in private sector demand, this is inadequate to pick up the slack in labor markets. At this pace, it may
be until 2013-2014 until the US unemployment rate matches its pre-recession level.

Nonetheless, US policymakers have determined that deficit reduction trumps addressing the unemployment issue. These
unnecessary cuts will increase unemployment and reduce tax receipts, further worsening the country's deficit. What's
troubling is that the imagined need for deficit reduction is driven by unnecessary fear. This is akin to having a child be
worried about monsters in the closet where none exists. In this case the monsters are the bond vigilantes. Policymakers
tell us they are out there, we just don't know it and we need to be ready for the day when they strike, even if it means we
wreck the economy and increase needless suffering in the meantime.

The bond vigilantes can't seem to be found in the US Treasury market. Through June 29, 2010, 30 year Treasuries were
going for 3.94% while 10 year Treasuries were at 2.97%. Yet somehow, even with the economy on the cusp of a potential
double dip and unemployment at tragic levels, policymakers have no interest in actually analyzing readily available data
(yields) and implementing policies that can offset the massive deleveraging occurring in the private sector. It is again
worth reminding that these policymakers had also fumbled with policy recommendations throughout the past five years
which lead to the current environment.

What would be useful is putting the private sector shortfall in perspective. According to Center for Economic and Policy
Research ("CEPR") economist Dean Baker, the implosion of the housing bubble led to a decline of $500B tied to the
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residential construction industry . An additional $100B was related to a decline in non-residential construction while the
actual decline in asset values tied to real estate led to a decline of over $500B in wealth driven consumption. This is over
$1T in spending that should be addressed. This is not to advocate aimlessly building homes or other items in those
sectors but to implement transitory programs to ease that shortfall along with investing in other areas that the US needs
investment (water pipelines for example which the Civil Corps of Engineers have deemed due for significant replacement)
which could absorb the slack in the labor force.

Unfortunately, policymakers will choose austerity and this view shared in the US and by many other countries will lead to
continued economic pressures and an overhang on any potential recovery. What broad deficit reduction entails is
ultimately every country hoping to manufacture surpluses through exporting. The reality is that not every country can do
this based on simple math. In addition, the biggest risk is that the world reverses its meager economic gains due to these
austerity measures. As the Guardian's Economics Editor Larry Elliott indicated, the US is on track to replicate the
economic decline experienced in the 1930s:

On arriving in the White House in 1933, Franklin D Roosevelt used government spending and tax breaks to boost
the economy. The US ran deficits of between 2% and 5% during FDR's first term but, while the economy started
to pull out of the deep trough reached in 1932, the national debt rose from $20bn to $33bn .

Coming up for re-election, Roosevelt heeded the advice of the "sound money" economists who delivered the
same sort of warnings that we are hearing today: the US was running unaffordable budget deficits that would
impose an intolerable burden on future generations. The budget for 1937 was slashed and the US economy
promptly went back into recession. Falling tax revenues meant the budget deficit rose to $37bn.

When deficit spending resumed in 1938, the economy started to grow again but did not fully recover until the US
entered the second world war. The deficit hawks disappeared into obscurity as the need to win the war trumped
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all other considerations. By 1945, the US budget deficit stood at more than $250bn or 120% of GDP.

This brief history lesson illustrates the risks we face by implementing austerity measures during a weak recovery.
Implementing heavy handed cuts only reinforces economic pressures. Cutting begets reduced tax receipts which
increases deficits. This prescription of slashing spending during an anemic recovery leads to an economic death spiral,
the historical evidence demonstrates this. More importantly, concerns about the levels of when a deficit is good or bad
are artificial. After World War II the US was able to deal with very high levels of debt to GDP.

Columbia University's Alan Brinkley, an expert on the Great Depression, shares the view that unemployment trumps
deficit concerns. "The Depression, as bad as it was, would have been much worse without the government
spending...and the 1937 effort to balance the budget — I think almost every economist would agree — was a
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catastrophe." Former economic adviser for John McCain's 2008 presidential campaign, Mark Zandi of Moody's, also
agrees. "Until unemployment is definitively moving lower, I think it's premature to be focused on reducing the deficits right
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now...we need to make sure that the economy is off and running before we pivot and begin to bring down deficits."

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To be sure, addressing debt and deficits is necessary but the gravest concern right now is unemployment and the
economy. Implementing both private and public sector deleveraging simultaneously in the worst financial and economic
crisis since the Great Depression is madness. Rather than focus on the numerator (debt), policymakers should focus on
the denominator (GDP).

1
http://www.nytimes.com/2010/06/29/business/global/29austerity.html?pagewanted=2&hp
2
http://www.cepr.net/index.php/blogs/beat-the-press/budget-deficits-and-the-gap-to-be-filled/#comments
3
http://www.guardian.co.uk/business/2010/jun/14/lunatics-economy-cuts-frankin-roosevelt
4
http://www.npr.org/templates/story/story.php?storyId=128087108
5
http://www.npr.org/templates/story/story.php?storyId=128087108

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