Austerity Will Make It Worse

 | Feb 28, 2013 | 11:00 AM EST
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I was talking to a friend of mine the other day about the $85 billion in spending cuts that will kick in as a result of the sequester, and he said, "Mike, you're being too negative, these are just scare tactics."

Scare tactics, perhaps. Too negative, maybe, but that $85 billion is only the tip of the iceberg. Actually, it will be more like $130 billion when the normal multipliers are applied -- most economists, including those at the Congressional Budget Office and the Office of Management and Budget, use a multiplier of 1.5. That means that for every dollar of spending that the government cuts, someone in the private sector will reduce spending by an additional $0.50.

Moreover, when you take into account the negative fourth quarter, you're going to subtract about another 0.8%, and GDP is going to be negative by 1.0% or perhaps more. That's not a scare tactic, that's just arithmetic.

These points didn't convince my friend, who said, "Look at Latvia. They imposed austerity and a flat tax, and now they're growing at 5.5%."

This was the example he was giving me? Latvia?

This is the revisionism currently being used by the hard-money "austerians." It's their way of justifying austerity, to make it appear as though it works. They'll look at a country like Latvia, which imposed brutal austerity in 2008-2009, causing the economy to contract by 40% and unemployment surge to 25%. Since then, the country has seen a feeble growth rebound of 5.5%, which is normal coming off these depression troughs. And the austerians seize upon this and say, "Aha! You see ... austerity works!" Well, maybe austerity works, but people sure don't. Latvia is still struggling with a 15% unemployment rate. But hey, they got a flat tax! Whoopee!

The same ridiculous revisionism was being applied in Europe not too long ago, when some of the most decimated countries, such as Spain and Greece, and even England, rebounded from deep contractions, prompting the pro-austerity crowd to point to that as evidence that austerity works. These were people who were not just casual observers like my friend but high-level policy makers. Not surprisingly, their voices have since been silenced as the economies in these respective countries have gone negative again under the weight of deep cuts.

To look at a policy that is designed to create depression and massive unemployment and cheer its "success" when feeble rebounds occur is not reality. It's not intelligence. It's just blind adherence to an ideology. The sad part is, look at how many people believe it. Most of the American public believes that we need to cut the deficit. That belief underpins the political support that is going to make this happen. In effect, the electorate is arguing against its own interests.

It may well be that the market and the economy will initially respond positively at the onset of the sequester. That's because, as I've written in previous columns, we have seen a huge injection of funds into net financial balances in February, as a result of a very large amount of deficit spending in the month and the very high level of tax refunds. I fully expect the Dow and S&P 500 to make all-time highs, and we could even see some decent improvement in the economic data. All this, of course, will make some people say, "You see ... austerity works!"

Then watch out.

Because the old adage "Sell in May and go away" is likely to be truer than ever this year. That's because all those financial balances will be returned to the Treasury in April as people and firms pay taxes. And by May, when austerity is in full force, there won't be anything to drive the economy, and we'll be heading down, hitting low after low and getting our heads above water only once in a while. Just like the success that is Latvia.

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