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Is the global economic recovery about to go into reverse? Watch Germany’s proposed spending cuts to see

posted on June 7, 2010 at 3:16 pm
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In gauging the dimensions of a crisis, you have to make certain assumptions. One thing I’ve assumed about the current euro debt crisis is that no politician there would do something unusually stupid. Venial. Short-sighted. Duplicitous. Sure. But not something so really stupid that it would raise damage from the crisis by an order of magnitude.

Well, I’m seeing exactly that level of “really stupid” starting to gather momentum. And the source is Chancellor Angela Merkel’s government in Germany.

Merkel’s government has proposed a $97.5 billion package of spending cuts and tax increases for 2011-2014, just when the struggling economies of the Euro Zone need its strongest economy to step up and spend more. The threat is not only that Germany will cut spending and reduce an already slow growth rate in Europe even further but also that Germany’s economic prestige as Europe’s most fiscally prudent economy will encourage other countries in the European Union to cut spending too.

Those spending cuts would ripple out across the global economy—remember that in aggregate the European Union is the world’s largest economy—at a time when growth seems very shaky in the United States and in some parts of the developing world.

Way back when this global financial crisis was younger—that is in September 2009—I wrote a post “We have nothing to fear but a replay of 1937 itself” http://jubakpicks.com/2009/09/22/we-have-nothing-to-fear-but-a-replay-of-1937-itself/  about how premature spending cuts in 1937 derailed a promising U.S. recovery from the Great Depression until the onset of World War II. I wrote then that I hoped U.S. politicians wouldn’t do anything stupid that could lead to a replay of the disastrously premature attempt to balance the budget. And I noted that Federal Reserve chairman Ben Bernanke at least was thoroughly familiar with the history of 1937 and determined not to preside over a U.S. replay.

To paraphrase Mark Twain History doesn’t repeat itself but it does rhyme. The danger of a replay of 1937 has reared its head again, but the source of the danger isn’t some U.S. politician but Germany’s Merkel.

Rejecting arguments by U.S. Treasury Secretary Tim Geithner that Germany in particular and Europe in general do more to promote “stronger domestic demand,” Merkel’s government has proposed what the Chancellor has called an “unprecedented” round of budget cuts. The program includes new taxes on air travel, new fees on electric utilities that operate nuclear power plants and a financial transaction tax on banks. Budget cuts include cuts to investments in infrastructure and spending on construction, reductions in child support, cuts of 10,000 government jobs, elimination of some extended unemployment benefits, and cuts of 40,000 from current troop levels of 250,000.

Interestingly the government has not proposed any cuts to the retirement or pension system. (For why those kinds of changes are the most necessary budget cuts in the long run see my post “Get used to it: the global debt crisis will play out over and over again over the next decades” http://jubakpicks.com/2010/05/25/get-used-to-it-the-global-debt-crisis-will-play-out-over-and-over-again-in-the-next-decades/

The cuts, taxes, and fees add up to about 2.7% of Germany’s GDP in 2009.

The government’s argument is that it has to cut a deficit projected at 5.5% of GDP in 2010. “The last few months showed, in connection with Greece and other euro countries, the overriding importance of solid finances,” Merkel said in explaining the plan. “2011 is the first year of the exit strategy.” The government plans to reduce the deficit to 0.35% of GDP by 2016.

Economists who are critical of the plan say that at worst budget cuts in Germany are exactly the wrong way to pull Europe out of its crisis and at best way too early.

Germany needs to be spending more—it especially needs to be raising wages to increase domestic consumption—if countries like Greece, Spain, and the United Kingdom are going to climb out of the hole that they’ve dug for themselves, critics say. These countries got into trouble by spending money that they didn’t have but Germany is making the European Union’s economic problem worse by not spending money that it does have. Germany runs an incredibly successful export economy—the country exported $1.12 trillion in goods in 2009, second in the world only to China’s $1.19 trillion in exports. But Germany’s consumers prefer to save rather than spend. In 2007 Germany’s savings rate was 16.7%. (In the United States the savings rate has recovered to 3.6% in April after bumping along near 0%) At the least that high German savings rate says that the country remains able to pay its modest (in comparison to 11% of GDP in the United Kingdom) budget deficit.

What’s wrong with savings? Nothing when the world isn’t struggling to recover from a collapse in global demand. Or when Europe’s weakest economies don’t need a few consumers to buy their goods or vacation on their beaches.

Commerzbank economist Eckart Tuchtfeld pooh-poohed Treasury Secretary Geithner’s worries in an interview with Bloomberg. “Mr. Geithner needn’t be perplexed about this program denting economic growth,” he told Bloomberg. At most it would cut 0.5 percentage points from growth each year.

Doesn’t sound like much—except that the Organization for Economic Cooperation and Development projects that the European economy will grow by just 1.2% in 2010. And that’s an increase from earlier projections.

And if more of the world’s richest countries adopted Germany’s tactics? The International Monetary Fund estimates that efforts to cut budget deficits in the richest countries now could cut as much as 2.5 percentage points off of global growth and put 30 million people out of work.

Budget cuts at some point, the IMF said, will be a good idea but in the next year or two the world economy needs more stimulus not less.

Germany’s budget cuts aren’t a dead certainty. The Merkel govermment has been steadily losing popularity and its opponents have pledged to fight the plan.

As St. Augustine would have said if he had been an economist, “O, Lord, help me to cut the budget deficit, but not yet.”

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27 comments

  • twoyrfixed on 7 June 2010

    I sold more stock this morning on this very worry. In my case, I did it because the GOP looks to have a lead in the fall General Election. Usually I don’t trade on one single thesis, but, the pressure for Conservatives to “back up” their rhetoric to attack the deficit will, I believe, crush the stock market.

    I’ll save the “it’s all just a Ponzi scheme talk” diatribe for later. As one of the Duke Brothers (Randolph?) said in Trading Places, “turn those machines back on!”

  • southof8 on 7 June 2010

    I wouldn’t worry too much about a GOP takeover of congress (at least, not for the reasons you mention). W ran on a platform of deficit reduction and, per this morning’s WSJ, presided over a 31% increase in non-discretionary spending, with a GOP congress aiding and abetting every step of the way.

    Faith based programs anyone? Medicare drug benefit? Tax cuts? Any politician of any party talking deficit reduction is full of hot air.

  • EdMcGon on 7 June 2010

    Jim,
    I’m sure there’s a perfectly reasonable explanation for the budget cuts. Maybe Merkel needs to save some money in order to send more to Greece?

    Ok, you can stop laughing now…

  • bobisgreen on 7 June 2010

    St. Augustine…understandable. Merkel…?
    Stupid…right answer.

    I’m beginning to side with Ed (OMG did I just say that!) Optimism beginning to wane. I did say in another post Europe needs to behave (something to that effect). Bear claws…horns…bear claws…horns…claws might win out.

  • DJBarber on 7 June 2010

    Went to all cash on 5/25.

    Sold all long term and short term positions.
    Was convinced I might have done the wrong thing.

    Sadly, days (And news like this) make me surer and surer that my decision to sell was not so bad after all.

    A few more days (And news articles like this) and I may be tempted to jump back in and re-buy my positions…

    The only question is, am I looking at September of this year, or next…….

    This whole PIGS thing reminds me of a Joke…

    “A doctor gave a man six months to live. The man couldn’t pay his bill, so he gave him another six months……”

  • mopama on 7 June 2010

    Let’s laugh a little more: Time to have a real private initiative in Europe with all State Controlled Economies Shrinking?

  • EdMcGon on 7 June 2010

    bobisgreen,
    Come over to the Bear Side… ;)

    P.S. Bear claws are yummy!

  • CallOfDutyFan on 7 June 2010

    southof8, did you do a typo?

    I thought W ran on a platform of *surplus* reduction.

  • bobisgreen on 7 June 2010

    Ed,

    I’ve been bull(headed) most of my life. Can’t do the claws…too many calories!

  • GlassWizard on 7 June 2010

    While it may not be good for Europe, how can it be bad for Germany? With the Euro down, exports should soar. A little tightening will keep pressure on domestic inflation.

    Club Med burns and if (shudder) the EMU fails, Germany is in a position of considerable influence over what remains. Then they “merge” with France…

  • mopama on 7 June 2010

    @ GlassWizard

    Well … maybe France… but look at Russia too.

  • yx on 7 June 2010

    Jim:
    Some guy at Merill Lynch reportedly said today that in order for double dip to happen, there must be policy-making mistakes. Such as raising rate and cut spending prematurely. However he left out raising taxes. As I read, both FDR and Japan raised taxes at very weak time and prolonged the depression in US and recession in Japan. A higher tax rate and other new taxes are kicking in soon. What’s your thoughts on chances of them causing a double dip?

  • yx on 7 June 2010

    It turns out, this iron lady is not that iron at all. She is quite wobbly when the real test comes.

  • andante on 7 June 2010

    Gold + gold miners are poping today. Flight to safety? Escape the bear.claws.

  • twoyrfixed on 7 June 2010

    Southof8,
    One of the problems with posting a thought on the net is, unless you’re Tolstoy(sp?), it’s hard to be perfectly clear. And I’m certainly no Tolstoy….

    You seem like a smart dude, but I’m perplexed why what Bush did or didn’t do in the past would matter in November? If you’re saying “they (GOP and Dems) are all the same”, I tend to agree. However, you don’t think in November of 2010, there won’t be pressure to cut stimulus, especially on the GOP side?

  • jamba on 7 June 2010

    Jim or Ed,

    With all the problems going on around the world right now, what is your opinion on what happens come Jan 1st 2011 when personal tax rates go from 35% to 39.6%, dividend tax rate increases, cap. gains tax goes from 15% to 20%, estate tax rate from 0 to 55%? If the economy gets softer in the second half of the year and unemployment remains high won’t the tax increases strangle what little growth there is and cause the economy to collapse?

  • southof8 on 7 June 2010

    Fixed, I’m no Tolstoy either. What I meant was I don’t think what politicians of any stripe promise to do during campaign season is among the various criteria investors should use to gauge market movements.

    Yes, they’ll all promise fiscal restraint. They always do. Will they deliver? IF the past is prologue for the future, not so much.

    And that is not a problem limited to the Donkeys- that was the point of the Bush reference.

    And tax cuts are a form of stimulus, so no, I don’t think the GOP will be cutting off the stimulus spigot. If anything, just the opposite. IT will just come in a different form- tax cuts rather than a “stimulus” spending bill.

  • samba on 7 June 2010

    Thanks Jim for writing another article about this topic

    If you think that euroland countries should wait to make the cuts in 1 or 2, or many more years time, what will be different at that time? In my humble opinion as long as the banks are sufficiently capitalized, why not cut now, spare bigger interest payments down the line. There will be a big drop in standards of living, like some countries experienced in the 70s and 80s, but eventually more stability for future generations, or is there even more to fear from this option?

    I find the alternative that the debt crisis will not be solved even over 2 decades a more unpleasant alternative

    The 1Tril Euros just pledged is to last 3 years, I think Germany must lead by example soon if it wants the big deficit Euro countries to follow through on large cuts.

    Cameron seems to be in agreement with germany, although our coalition might not be around to make it happen

  • yx on 7 June 2010

    Did someone mentioned Cameron of UK? I really like him so far.

  • findus on 8 June 2010

    I believe even (comparatively) well off EU countries are looking at a possible future credit crunch and acting to avoid it . Denmark, where I live, is facing a situation where we could be looking at maybe 40 years’ of huge national debt (most recent estimate), due to overspending, rising uneemployment and changing demographics (decreasing workforce, increasing numbers of retired). Without budget cuts, many European countries will be looking at sharply increasing costs of financing the deficits. The increasing costs would, of course, contribute to the problem, making achieving balanced budgets even more difficult – as do the cuts that will slow down the economies and reduce income.
    To me it seems that both paths – spending or cuts – will lead to inevitable decline. Is there a third option? The mantra right now is cuts – in GB, Germany, Denmark, France … to name a few)

  • EdMcGon on 8 June 2010

    jamba,
    Raising taxes during a weakened economy is committing economic suicide. We saw it in 1937, and we’ll see it again in 2011.

  • rolfer1 on 8 June 2010

    So Jim, despite having argued against profligate spending on this site in the past, you seem to now support it — expedient yes, prudent no. Yes, yes, spend, spend, spend.

  • IanCClarke on 8 June 2010

    findus,
    there’s a third possibility: issuing and using a complementary currency alongside the national currency. This would not be a solution, but would allow – or at least help – to maintain the current public spending levels without digging the grave even deeper (the keyword being maintain, else the risk of runaway inflation).
    The government can issue such a currency and use it to pay public workers and pensions; the people can then spend it – within the national borders – as if it were the official currency, and finally use it to pay taxes, sending it back to the government where it can be recycled without issuing more. There are (significant) technical issues you must deal with, but it would definitely be possible.
    You would end up: 1) easing the liquidity crunch by increasing the quantity of money in a controlled and targeted fashion and at no cost for the government, and: 2) buying more time for the country to grow out of the current quicksands.

  • sigli on 8 June 2010

    I don’t see why prudence and restraint has to be so scary. If they turn this around then we’ll see stagflation eat up the standard of living. If we double dip then that will eat up the standard of living. There is no free lunch. Innovation is the closest thing to it, and, as far as I can see, that’s what we’re all really praying for to counter the inevitable inflation from monetary and fiscal policy, and from China.

    The US standard of living is going down regardless of the route. We can either take the pain quickly, or go all Japan and fail to restructure for years. Innovation may help to offset the decline, but decline it will.

    The way I see it, there’s nothing wrong with a few more mothers staying home and a few more fathers who are worked to the bone deciding to give education a shot. That’ll lower the precious GDP for a while, but we’ll reap dividends down the road.

    Is restructure really a thing of the past?

  • wwlettsome on 8 June 2010

    It will be interesting to see what happens to US spending over the next couple of years and the Bush tax cuts expiring beginning of next year…we could very well be looking at double whammy of decreased spending and increased taxes. We may soon be wishing for the good ole’ days of early 2010. Guess then we will have someone else to criticize for being “stupid” besides Ms. Merkel.

  • twoyrfixed on 8 June 2010

    South,
    Good points, but I don’t see a GOP congress and a Dem Pres agreeing on “rich guy” tax cuts nor current spending levels. That’s why I’m 50% cash for the first time in ages. Interesting thoughts on this board. Once you wade through the politics it looks like there is a general consensus about the US being boxed into a corner.

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