Austerity's Greatest Failure

Let's play a game. See if you can spot which countries have tried austerity and which ones haven't, based on their 10-year bond yields over the past three years.





Okay, lock in your answers. Here's the big reveal: the first country is Portugal (austerity), the second is the United States (no austerity), and the last one is the United Kingdom (austerity). See how much cutting deficits saved the U.K. on borrowing costs compared to the U.S.? Try squinting.

A few disclaimers. Low bond yields aren't necessarily a good sign. In a liquidity trap, they're not. (More on that in a bit). But it does show the bankruptcy of the arguments of the austerians. They peddled budget cuts as 1) the path to prosperity and 2) the only way to regain market confidence (that was never lost). Recent history has shown that both of these claims were spectacularly wrong. Not only has the U.K. entered a double-dip recession, but it's even underperformed the euro zone since Cameron took office and started reducing the deficit. Unless austerity is offset by monetary easing, contractionary fiscal policy is indeed contractionary.

Great Britain's experiment has been all pain and no gain. Britain's budget cuts haven't even bought them any more credibility in the eyes of markets than America's relatively spendthrift ways have. What's going on here?

Three broad factors explain the above bond yields. First, does a country have its own central bank? Second, is its economy growing (and if so, how quickly?) And third, how big is its deficit? Let's consider how these factors apply to each of the above countries.

Portugal is in big trouble. It's part of the euro, so it can't print money. That means that its monetary policy isn't set to maximize Portugal's growth. And that's really bad news. Investors worry that Portugal won't be able to grow enough to pay back what it already owes, let alone any new debt. It's left with no choice but to embrace austerity. But that doesn't help its borrowing costs, because -- still -- it's not growing. It's a doom loop for national bankruptcy.

Lucky for us, we have the Fed. Investors aren't worried about us getting stuck in a full-on depression. But they are worried about us getting stuck in a lost decade. And, ironically, that's good news for our borrowing costs. While a Portugal-style collapse could threaten our ability to pay back creditors, a prolonged period of low growth means that there aren't a lot of good investment options. But government bonds are safe. So the worse things look, the better for our bond yields. Notice that I haven't said anything about deficits yet. Markets aren't concerned about them when the economy is depressed.

That's the mistake Cameron's government made. They thought deficits mattered more than growth. They don't. That's not to say that Britain's budget cuts haven't reduced borrowing costs. They have. But not for the reason Cameron hoped for. Rather than "restoring confidence" in Britain's finances, austerity has destroyed confidence in Britain's growth. And, again, that's good news for borrowing costs. But it just shows how unnecessary austerity has been. Britain probably wouldn't be paying much, if any, more to borrow even if they hadn't narrowed their deficit. Consider that since Cameron was elected, British yields have fallen 181 basis points while American yields have fallen ... 170 basis points. But even if Britain did pay more, that would be good news! It would mean that their economy is growing enough that investors are more worried about inflation than low-growth.

I'm not saying that deficits never matter. I'm saying they don't matter now. If deficits are structural, markets eventually will lose confidence in a government. For us, that means we need to rein in healthcare spending, which is the big driver of our long-term debt problems. But we have to get to the long-term first. We shouldn't worry about deficits in the short-term. Doing so is unnecessary and self-defeating. Just ask David Cameron.