Austerity American Style

The artificially engineered U.S. recovery is already starting to falter as a fusillade of weakening data continues to shoot the economy full of holes. Recent numbers on GDP, durable goods, housing, regional manufacturing, initial unemployment claims and leading economic indicators all indicate a sharp slowdown in GDP growth. All this comes at a time when the government is concurrently contemplating ways to dramatically cut spending. But is America really ready to accept the short term consequences involved in ending government support for the markets and the economy?

Free market disciples (like me) believe that government intervention is anathema to a healthy economy. On the contrary, we believe genuine government stimulus comes from low taxes, stable prices, reduced regulation and low debt. Our economic policy makers have scrupulously avoided such remedies. However, in the short term, it is possible for government central planning to artificially boost GDP. But as the short term is coming to an end, Washington’s heavy hand is sending this artificial recovery down the drain.

When a country spends in order to stimulate growth it sources money from three methods: taxing its citizens; borrowing from the existing pool of capital, or borrowing newly created money from its central bank. All three options are economically poisonous.

The act of taxing one sector of the economy in order to redistribute wealth to another can never be considered stimulus. How can taking money from Citizen A and giving it to Citizen B improve the outlook for both? To think that it could assumes that the government knows the best way to allocate resources. But everything I have ever seen tells me that this is not so.

A government could instead distribute money borrowed from the private sector’s existing pool of capital into targeted areas of the economy. But this type of “stimulus” is simply a deferred tax with interest. Any money borrowed by government could have been utilized by the private sector to expand business and grow the economy. Instead, money spent by government makes no lasting economic impact.

Some liberal economists argue that funds left in the private sector would likely be saved, rather than spent, during an economic downturn—thus exasperating the recession–if not for government activism. This may be true, but necessity, in the form of weak balance sheets, is the factor that usually drives the private sector to save. Any interference with that deleveraging process has dire consequences in the long term. Government borrowing only delays the eventual pain because a significant tax increase will eventually be needed to pay down the added debt associated with public liabilities. If the private sector is prevented from paying down debt, the debts will simply be transferred, with interest, to the public ledger. Therefore, borrowing to spend should not be considered a genuine stimulus.

Finally, a government can acquire spending power from outside the existing domestic savings pool by borrowing newly printed money. That new money enters the economy in the form of deficit spending. However, the inflation created by the central bank printing has its downside.

At first, the economy experiences a combination of higher prices and growth. Producers raise prices as the domestic currency loses its value, while others are deceived into believing the value of money has remained unchanged; and so they increase their production and expand real GDP. However, the greater extent and duration in which the central bank perpetuates their printing, the less real growth and the more inflation the economy will experience.

This is precisely the recipe that we are currently following. Between 2008 and 2010, the Federal government borrowed over $3.1 trillion. It is expected to run-up another $1.5 trillion in debt this fiscal year. Meanwhile, the Federal Reserve has increased their balance sheet by nearly $2 trillion in order to accommodate the massive increase in public sector borrowing.

By borrowing printed money, the government had been able to perpetuate our consumption driven economy, while simultaneously levitating most asset prices—even home prices have been prevented from falling to a level that can be supported by the free market. The Fed’s desire to create inflation and support prices had at last driven up industrial commodity prices like copper to all-time nominal highs. Once oil prices crashed through the $100 per barrel level, the Fed was forced to ratchet down its inflationary rhetoric. The question now is whether actions will follow.

The Fed and administration have now reached the point of diminishing returns. Whatever anemic and temporary growth that was generated by borrowing and spending printed money is now being superseded by rising prices. Any further monetary stimulation from this point on will only serve to send aggregate price levels surging higher, as GDP growth falls. The bottom line is that borrowing and printing money can never increase productivity and labor force growth, which are the only ways to increase real GDP. Government intervention can only temporarily circumvent the deleveraging process that is necessary for viable growth.

The government’s window to artificially drive real GDP growth by borrowing and spending has closed. The U.S. economy now faces another recession head-on, as the private sector deleveraging process resumes and the public sector deleveraging process begins. Alternatively, the Fed can keep expanding their balance sheet and sending the economy deeper into stagflation. The salient question for investors is whether the next recession will be accompanied by inflation or deflation. But only Mr. Bernanke can answer that.


Michael Pento

Michael Pento is Senior Economist and Vice President of Managed Products at Euro Pacific Capital. Besides blogging daily at, he writes a weekly market commentary that is carried by Forbes and the Huffington Post. Michael is a regular guest on CNBC, Bloomberg, and Fox Business, as well as regular guest host of The Peter Schiff Show.