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It struck me as highly unusual for a group of European leaders, many of whom were brought up in the cradle-to-grave welfare systems of their respective countries, to talk so passionately about budget cuts in the G20 conference in Toronto.
Their rhetoric seems to suggest that austerity, which has been for as long as one can remember a dirty word in European politics, is now firmly back in vogue. The newly elected conservative government of the UK has actually drawn up a detailed plan to drastically cut government spending in the coming years.
All these sounded rather scary at a time when expansionary fiscal policy is needed to prevent the global economy from slipping back into a deep recession. The United States government is debating whether it should pursue its own economic stimulus program or to follow the European trend.
The argument put forward by austerity proponents that a more disciplined budgetary policy can generate greater confidence in the economy, leading to increased investment by the private sector, has been brought into question by some of the world's leading economists. In his column in the New York Times, Nobel laureate Paul Krugman posed this question: "What's the evidence for the belief that fiscal contraction is actually expansionary, because it improves confidence?"
Citing Ireland as an example, Krugman noted that government belt tightening at a time of economic contraction could lead to a depression-style slump. Indeed, the United States recovered from the Great Depression in 1930 not by spending less, but by spending more.
Belt tightening in Europe, if sustained, can most likely, at least in the initial phase, choke growth and push up unemployment, resulting in a decline in final demand. This could lead to a reduction of merchandise imports from emerging economies, particularly China.
But it is not clear how deep a cut the people of various European nations will allow their governments to make and for how long. Even some relatively mild austerity measures have already triggered strong public protests in France and Spain.
The Greek sovereign debt crisis has reinforced a fashionable notion that bond traders around the world have become increasingly nervous about the financial stability of countries running overly large budget deficits. Perhaps the call for austerity was made to pacify the "bond vigilantes" who, as defined by Krugman, are "investors who pull the plug on governments they perceive as unable or unwilling to pay their debts."
The markets were so nervous that a recent rise in long-term interest rates was sufficient to generate worries that these "bond vigilantes" were poised to pounce on the United States. Although interest rates have gone down since then, worries about a possible bond market showdown have continued to be fanned by advocates of spending cuts.
In these stressful times, it is important that creditors keep calm and exercise caution in words as well as deeds. Deep spending cuts by the US government, which could short-circuit the fledgling economic recovery, would not be in the interests of the emerging economies that continue to count on overseas demand for their goods to maintain the momentum of growth.