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Sunday, June 06, 2010

"What Do Markets Want?"

The G20 recently recommended that countries begin reducing their budget deficits immediately. The argument is based upon the idea that "giving the markets what we think they may want in future – even though they show little sign of insisting on it now – should be the ruling idea in policy." However, the recovery is still relatively weak, and Kevin O'Rourke wonders why the G20 wants to risk sending Europe back into recession. He argues that "low unemployment and economic growth are among the fundamentals which have to be right, if government policies are to be credible in the eyes of the markets." Cutting deficits now, before the economies have recovered sufficiently, risks upsetting markets by causing lower growth and higher unemployment:

What do markets want?, by Kevin H. O'Rourke: The news that the European Commission's Economic Sentiment Indicator fell sharply in May underlines the economic risks the continent is now facing. With governments around Europe moving towards fiscal austerity,... the danger that Europe will move back into recession seems clear.

Why are European governments embarking on such a risky strategy? ... What ... do markets want? As it happens, the EMS crisis of 1992-1993 taught us a lot about what markets want. ... Readers will recall that the commitment of peripheral European economies to stick to the Deutschemark was brought into question when German interest rates started to rise in the wake of German reunification, and countries like Italy and the UK started to suffer serious competitiveness problems. The initial response of politicians was a macho one: get the fundamentals right and the problem would go away. The fundamentals concerned were, of course, low inflation, low deficits, and low levels of government debt...: if governments could gain credibility in the markets' eyes, the speculation against their currencies would stop.

However, the speculation did not stop, leading once again to the question: what do markets want?
The lesson of the EMS crisis is that low unemployment and economic growth are among the fundamentals which have to be right, if government policies are to be credible in the eyes of the markets. ... Speculators bet that governments would not, in the long run, be able to sustain policies which led to rising unemployment: far from enhancing credibility, the 'responsible' and deflationary policies which governments thought markets wanted fatally undermined it. And thus ... the market forced governments in the UK and elsewhere to adopt policies that were softer, and more growth-oriented, than what orthodoxy had been demanding. ...
The lessons ... seem clear. Markets may indeed not be willing to lend to peripheral governments unless they take remedial action to fix their public finances: so be it. But in the long run, markets will not be willing to lend to countries whose economies are continually contracting. ... Too much austerity at the wrong time will not make governments more credible, but less so. ...
Those economies with fiscal space need to use it now. Furthermore, we should be asking whether the European Union as a whole, or perhaps the eurozone, might be such an economy. Major European investments in new transportation and energy infrastructures are needed in the long run anyway. If the Union embarked on them now, it would become part of the solution to our problems: if it becomes a mechanism for imposing asymmetric and deflationary adjustment on the continent, it will be seen, rightly, as one of the causes.
And the markets won't like that.

Paul Krugman isn't happy with the G20's recommendation for austerity either. See here.

    Posted by on Sunday, June 6, 2010 at 01:26 PM in Economics, Fiscal Policy | Permalink  Comments (33)


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