Honey, I shrunk the economy (Anglo-Saxon capitalism edition)

It is an error to think that fiscal austerity is a threat to growth and job creation. At present, a major problem is the lack of confidence on the part of households, firms, savers and investors who feel that fiscal policies are not sound and sustainable. In a number of economies, it is this lack of confidence that poses a threat to the consolidation of the recovery. Economies embarking on austerity policies that lend credibility to their fiscal policy strengthen confidence, growth and job creation.

So said former ECB president Jean-Claude Trichet in an interview with Liberation on July 8, 2010. Lately, two natural experiments have been conducted regarding austerity. In the US the fiscal cliff threatened to bring strong cuts to government spending, especially in the military budget. So, insecure about what would happen, the military spent less. We now would expect the austerity to free workers to work in the private sector. The NY Times reports the result of this:

The economy contracted at an annual rate of 0.1 percent in the last three months of 2012, the worst quarter since the economy crawled out of the last recession, hampered by the lower military spending, fewer exports and smaller business stockpiles, preliminary government figures indicated on Wednesday. The Fed, in a separate appraisal, said economic activity “paused in recent months.”

There is another case where austerity has been tried. In the United Kingdom, premier minister David Cameron has declared: ““Obviously it’s been a very tough time to be in government but I think the most important thing is we’ve given Britain a secure plan for getting out of the debt and the deficit and the difficulties that we inherited.”

The “difficulties” are hard to understand. Government debt to GDP has risen, but the interest rates the government has to pay on new government bonds is the lowest in a life time (same for the US, by the way):

Nevertheless, austerity policy it is for the United Kingdom, and the results do not look very promising. Last week The Guardian reported:

Britain could be on course for its third recession in four years after the economy shrank 0.3% in the last three months of 2012.

The figures were worse than expected and could put pressure on the government to consider a “plan B” that would stimulate demand.

A fall in manufacturing output dragged down the economy, countering a small rise in construction between October and December, according to the Office for National Statistics. The economy achieved zero growth for the year as a whole.

So, we had two experiments where policy-makers decided to lower government spending (without being pressured by high and rising bond yields). In both cases the economy reacted by shrinking. This should lead to some serious re-thinking on the macroeconomic policy front.