For Germany, U.K. and U.S., Deficit Cuts Now May Sink Economy

When they began as a baseball National League expansion team in 1962, it was said the New York Mets, who lost 120 games that year, were so bad they could "snatch defeat from the jaws of victory."

Well, it appears certain policy makers in Germany, Britain, and the U.S. are campaigning for the same label as Casey Stengel's Mets. The reason? The economic recovery is barely a half-year old, it's showing signs of a possible stall, and lawmakers want to cut budget deficits.

You read correctly. Unemployment is high. The recovery is fragile. So what we need to do is take more demand out of the economy? How novel.

And how misguided. Germany has already announced fiscal cuts totaling €80 billion or $98 billion, Britain under new Prime Minister David Cameron is expected to cut its deficit by 40 billion pounds or about $60 billion, and in the U.S., pressure is building on Congress to cut the deficit -- lawmakers have even refused to fund an extension of unemployment benefits for millions of Americans, despite the fact that many can't find work because there's so little hiring.

Before examining the consequences of the above, let's evaluate the rationale for the developed world's new "austerity obsession."

Are Bond Vigilantes Really a Threat?

One theory argues that the deficit-cutting mood has been prompted by the 'bond vigilantes,' largely institutional investors who punished Greece and other debt-plagued eurozone nations by selling their bonds and driving up their interest rates -- forcing them to cut their deficits. If they didn't, the indebted countries ran the risk of the vigilantes dumping their bonds altogether, cutting them off from their primary source of international capital.

But does anyone really believe that institutional investors are going to dump bonds from the three economic giants, Britain, Germany, and the U.S., in a comprehensive and systematic way if they delay their deficit reduction until after the recovery has taken hold?

Presumably the proponents of this argument believe investors will shift their money to "safe" investments in China (talk about oxymorons), or to Japan's bonds, which pay about 2% for a 20-year note. Wow. What a deal clincher. That yen-based two percenter would certainly get me to rotate out of U.S. Treasuries and corporates.

Miniscule Inflation

A second theory argues that deficits have to be cut to prevent inflation. Question is: Prevent inflation where? Britain's inflation rate is declining, and Germany's inflation is about 1.2%. U.S. consumer prices fell 0.4% in 2009, probably won't rise more than 2% this year, and the Federal Reserve will be happy if prices do rise that much -- happy because there's substantial risk of deflation taking hold. There's little inflation, hence the notion that budget deficits need to be cut to contain it is specious.

Further, not every economy watcher is enamored with the early austerity measures. One banking sector professional argued that Britain's deficit cutting is a test case.

"This is going to be one of the biggest experiments, and the U.S. can sit and watch and look to see what happens to the U.K. output data, which I suspect is about to collapse," David Blanchflower, a former Bank of England policy maker, told Bloomberg on Friday.

Electoral Expediency

Given that the bond vigilante and inflation issues are not credible, what then is motivating the deficit cutting? Well, certain elected public officials have felt pressure from their constituents over stimulus spending and other financial crisis-prompted interventions, and in the U.S., it's an election year.

And that, folks, is the real source of the deficit-cutting determination -- electoral expediency.

But cutting budget deficits now takes demand out of the system -- exactly what the major economies of Britain, Germany, and the U.S. do not need given the still-fragile recovery. The spending cuts and tax increases could tip these economies back into recession.

And if a double-dip recession ensues and unemployment starts rising again, policy makers who thought their austerity measures would cool things off will begin to feel a stronger electoral heat -- from a different direction.