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July 2010

Is Austerity the Road to Ruin?


James Montier

L et me share with you one of my guilty secrets: I


occasionally indulge in the dark art of
macroeconomics. I don’t try to forecast the future (that
on the incomes of others makes it impossible for
all individuals simultaneously to save any given
sums. Every such attempt to save more by reducing
would be truly pointless), but I do think that understanding consumption will so affect incomes that the attempt
the macro backdrop can, on occasion, help inform the necessarily defeats itself. It is, of course, just as
investment process. For instance, those who understood impossible for the community as a whole to save
the impact of a bursting credit bubble stayed well clear less than the amount of current investment, since the
of the value trap opportunities offered in financial stocks attempt to do so will necessarily raise incomes to a
during 2008. Those who focused purely on the bottom-up level at which the sums which individuals choose to
tended to plow in and repent at leisure, as the deteriorating save add up to a figure exactly equal to the amount
fundamentals generated a permanent loss of capital. of investment.
So why share this confession now? I think we are seeing In essence, the paradox of thrift is a fallacy of composition.
a very worrying trend around the world: the rise of the Whilst it may be perfectly rational for one household
Austerians. This breed is the latest incarnation of what (or section of the economy) to save more, if everyone
used to be called the deficit hawks, a group set upon tries to save more, total income is lowered. If you aren’t
reducing what it sees as the government’s profligate spending, then neither are the people who depend upon
spending. you for their source of income. Firms won’t invest if
there is no demand for their products, and we end up in a
The power of the paradox of thrift nasty downward spiral.
The Austerians either ignore or dismiss the paradox of
An alternative presentation was provided by my good
thrift. This paradox (which appears first in the Fable of
friend, Rob Parenteau, in one of John Mauldin’s “Outside
the Bees1) was popularized by John Maynard Keynes in
the Box”2 columns earlier this year. Parenteau reminds
The General Theory of Employment, Interest and Money.
us that:
He wrote:
Domestic Private Sector Financial Balance +
For although the amount of his own saving is unlikely
Fiscal Balance + Foreign Financial Balance = 0
to have any significant influence on his own income,
the reactions of the amount of his consumption This makes it clear that it is impossible for all sectors to
1  “As
net save at the same time. As Parenteau notes, this isn’t a
this prudent economy, which some people call Saving, is in private
families the most certain method to increase an estate, so some imagine theory, it is an accounting identity. If this is wrong, then
that, whether a country be barren or fruitful, the same method if generally so are hundreds of years of double-entry bookkeeping.
pursued (which they think practicable) will have the same effect upon a
whole nation, and that, for example, the English might be much richer
than they are, if they would be as frugal as some of their neighbours. This,
2  http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/
I think, is an error.” Bernard Mandeville, The Fable of Bees: or, Private
Vices, Publick Benefits, 1714. archive/2010/03/09/the-european-union-trap.aspx
He creates a useful map to think about the paradox of mode, then the financial fragility of the economy is
thrift (Exhibit 1). The diagram rearranges the equation likely to increase, raising the probability that more fiscal
above such that: spending will be needed in the future.
Domestic Private Sector Financial Balance = The lessons of history
Current Account Balance – Fiscal Balance
In early 2009, Christina Romer, Chair of the Council of
The 45-degree line marks the points where the current Economic Advisers, gave a speech laying out six lessons
account balance is equal to the fiscal balance, and thus from the Great Depression.3
the private sector balance must be zero. To the left of
Lesson I: Small fiscal expansion has only small effects.
this line, the current account balance is less than the
fiscal balance, and the domestic private sector is deficit Lesson II: Monetary expansion can help to heal an
spending. To the right, the current account balance is economy even when interest rates are near zero.
greater than the fiscal balance, and the domestic private
Lesson III: Beware of cutting back on stimulus too
sector is running a financial surplus (net saving).
soon.
As Parenteau points out, “The financial balance map
Lesson IV: Financial recovery and real recovery go
forces us to recognize that changes in one sector's
together.
financial balance cannot be viewed in isolation, as is the
current fashion. If a nation wishes to run a persistent Lesson V: Worldwide expansionary policy shares the
fiscal surplus and thereby pay down government debt, burdens and the benefits of recovery.
it needs to run an even larger trade surplus, or else the Lesson VI: The Great Depression did eventually end.
domestic private sector will be left stuck in a persistent
deficit spending mode.” Of relevance to our current concerns are Lessons III and V.
The huge monetary expansion caused by the U.S. leaving
This framework also highlights one of the great ironies of
the Austerian’s approach. If a fiscal surplus is pursued, 3  The
Great Depression is the subject in which Romer made her professional
Exhibit
and the 1 sector is stuck in deficit spending
domestic private name. Full text at: http://www.econ-pol.unisi.it/fiorito/c.romer_rec09.pdf

Exhibit 1
3 Sector Financial Balances Map
Domestic Private
3 Sector Financial BalancesSector
Map Financial Balance = Current Account Balance – Fiscal Balance
Domestic Private Sector Financial Balance = Current Account Balance - Fiscal Balance

Fiscal Surplus

DPS Deficit DPS Deficit DPS Surplus

Current Account Current Account


Deficit Surplus

DPS Deficit
DPS Surplus
Domestic Private Sector
Financial Balance = 0%
DPS Surplus

Fiscal Deficit
Source: Parenteau (2010)

GMO
Source: Parenteau (2010)
2 Is Austerity the Road to Ruin? – July 2010
the Gold Standard seems to have produced remarkable share the hallmark of being adjustments occurring in
results in terms of real growth: the U.S. economy grew small, open economies with weak currencies at a time of
by 11% in 1934, 9% in 1935, and 13% in 1936 in real generally healthy global growth. These are about as far
terms! This lulled the authorities into thinking that all removed as one can imagine from the circumstances that
was well with the system again. Hence, in 1937, the the world faces currently.
deficit was reduced by approximately 2.5% of GDP.
If the examples of history are ignored (as is all too often
Monetary policy was also tightened. As Romer notes,
the case) then policy error is likely to be a serious source
“… the Federal Reserve doubled the reserve requirement
of deflationary pressure. This is the last thing a debt-
in three steps in 1936 and 1937… taking the wrong turn
laden economy needs, especially a debt-laden economy
in 1937 effectively added two years to the Depression.”
that is teetering on the brink of deflation anyway. But
Lesson V is also of marked interest as the Austerians seem that doesn’t mean that policy makers won’t try to tighten.
to have gained a higher degree of influence in Europe Indeed, one of the world’s worst economists and a
(including the U.K.) than they have currently in the U.S. paragon of orthodox belief, Alan Greenspan, opined in
Japan provides us with another example of the unerring a recent Wall Street Journal OpEd that “an urgency to
ability of policy makers to snatch recession from the rein in budget deficits” is “none too soon.” Did you need
jaws of recovery. Time and time again in the post bubble more evidence that this was a really bad idea!?!
period, the Japanese policy makers have beaten an Exhibit 3
Exhibit 3
incipient recovery over the head with overly aggressive G7 Inflation (YoY, %) – No margin for error
tightening measures. Most relevant for the Austerians
14
was the experience in 1997, when the authorities raised
the consumption tax by 2% and plunged the economy 12
back into a recession. 10

Exhibit 2 8

Japan:
Exhibit 2 A prima facie case against premature 6

tightening (YoY, %) 4

8
2
Consumption tax
6 increase
0
4
-2
2 Jan-1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

0 Source: Datastream
-2

-4 One can understand the pressure being placed upon


-6
policy makers. They are caught between a rock and a
-8
hard place. On one side, the Austerians and the (albeit
invisible) bond vigilantes argue that unless governments
-10
Q1- 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 act, there will be sovereign debt crises left, right, and
Source: Datastream center. On the other side, the Keynesians (like me) argue
that tightening will lead to a relapse into recession.
In fact, Alesina and Ardagna4 examined 107 fiscal In an effort to find some common ground between the
retrenchments in the OECD countries between 1970 warring factions, Olivier Blanchard and Carlo Cottarelli5
and 2007. A mere 26 of them occur with growth, whilst have suggested the following Ten Commandments for
the others are all deflationary. The minority essentially fiscal adjustment in developed economies:

4  Alesina and Ardagna, “Large Changes in Fiscal Policy: Taxes vs. Spend-
5  Blanchard
ing,” 2009; forthcoming in Tax Policy and the Economy, available at: and Cottarelli, “Ten Commandments for Fiscal Adjustment in
http://www.economics.harvard.edu/faculty/alesina/recently_published_ale- Advanced Economies,” 2010, http://blog-imfdirect.imf.org/2010/06/24/
sina ten-commandments-for-fiscal-adjustment-in-advanced-economies/

Is Austerity the Road to Ruin? – July 2010 3 GMO


Commandment I: You shall have a credible medium- First on the menu was aggressive currency depreciation;
term fiscal plan with a visible anchor (in terms of either second was the introduction of an inflation target; third
an average pace of adjustment, or of a fiscal target to be was money-financed transfers (effectively, tax cuts
achieved within four to five years). financed by printing money); and, finally, quantitative
Commandment II: You shall not front-load your fiscal and qualitative easing. Ergo, the “good news” arising
adjustment, unless financing needs require it. from an Austerian victory would be the rapid arrival of
QE II.6 Thus any short-term deflation will ultimately
Commandment III: You shall target a long-term decline lead to long-term inflation pressures.
in the public debt-to-GDP ratio, not just its stabilization
at post-crisis levels. The portfolio implications – the quest for
Commandment IV: You shall focus on fiscal robustness
consolidation tools that are conducive to strong potential A flight path that contains short-term deflation and
growth. long-term inflation suggests the need for portfolios that
are robust. Indeed, robustness is a much neglected
Commandment V: You shall pass early pension and
trait in portfolio construction. In the past, I have often
health care reforms as current trends are unsustainable.
talked about the need to consider cheap insurance in
Commandment VI: You shall be fair. To be sustainable circumstances where we simply don’t know the outcome
over time, the fiscal adjustment should be equitable. of events. One of the better definitions of risk that I’ve
Commandment VII: You shall implement wide reforms come across is that more things can happen than will
to boost potential growth. happen. The distribution of possible future outcomes is
wider than the ex post singularity of history. Thus, one
Commandment VIII: You shall strengthen your fiscal can seek to construct portfolios that are protected under a
institutions. number of different possible scenarios.
Commandment IX: You shall properly coordinate
In accordance with our 7-year forecasts, we generally
monetary and fiscal policy.
think that bonds are a lousy investment – although possibly
Commandment X: You shall coordinate your policies not as a speculation. Ben Graham said, “An investment
with other countries. operation is one which, upon thorough analysis promises
safety of principal and a satisfactory return. Operations
Many of these suggestions seem sensible to me. However,
not meeting these requirements are speculative.”7 Judged
ultimately and thankfully, policy making is beyond my
from a long-term perspective in which inflation must be a
pay grade. I just have to work out what all of this means
concern, bonds look exceptionally unattractive.
for portfolios (more on this later, I promise).
However, if deflationary pressure builds as a result of the
Deflation, the route to inflation Austerians, then bonds could well be a good speculation.
If the Austerians and their ilk win the day, we may see How does a long-term value manager like GMO deal
some short-term deflationary pressures and, as noted with this conundrum?
above, they will be even more dangerous than they were
Generally, we simply can’t bring ourselves to own bonds
previously because we are starting with no margin of
at the yields on offer in most markets today. However,
safety in terms of the inflation rate.
that doesn’t mean we are ignoring the short-term risks.
However, the U.S. at least has a central banker who So whilst we are generally inclined to be short nominal
seems to understand the risk. Despite his complicity in duration across portfolios (as suggested by the 7-year
getting us into this mess in the first place, Ben Bernanke forecasts), we have been adding nominal duration.
has shown he understands the risks that deflation poses, How can one add nominal duration when bonds are
especially in a debt-laden economy, and believes that overpriced? Doesn’t this imply that we are betraying our
he has sufficient tools to prevent deflation from gaining value investing credentials?
traction in the economy (even with rates at zero). Indeed,
he has given speeches where he has laid out a menu of
6  Quantitative Easing II.
policy options in the event of deflation risk. 7  Graham and Dodd, Security Analysis, McGraw-Hill, 1934.

GMO 4 Is Austerity the Road to Ruin? – July 2010


Thankfully, no. There are a couple of bond markets that which our portfolios would be exposed to intensifying
are still essentially at fair value (based on our measures): short-term deflation pressure. If deflation does arise,
Australia and New Zealand both offer government bonds most likely we will be on the look-out for longer-term
that look to be fairly priced. Are we happy about buying insurance against inflation. Ultimately, I suspect that
fair-priced bonds? Of course not. We are happy only is where we will end up. (And remember, the time to
when we buy cheap assets. However, these fair-priced purchase insurance is when no else wants it as it’s likely
bonds provide us with some useful insurance, without to be cheap.)

Exhibit 4Exhibit 4a
GMO 7-Year Asset Class Return Forecasts
As of June 30, 2010
-Expected Value Added
-Real Return (Asset Class Index)
Stocks Bonds Other
12%
10.3%
Annual Real Return Over 7 Years

10% 9.1%
6.5 % Long-term
3.7% Historical U.S.
8% 1.8%
7.2% 7.5%
Equity Return
1.5%
6% 2.3% 5.2% 5.1%
4.7%
4% 1.8%
2.3%
2.9% 7.3%
6.6%
2.9%
6.0%
4.9%
2% 1.8% 1.4%
2.9% 2.9% 1.0% 0.1% 1.0%
2.2% 0.9%3
1.1% 0.9%3 0.9% 1.4%2
0.5%
0% 0.1% -0.8% -0.4%

-2%
U.S. U.S. U.S. High Int'l. equities Int'l. equities Equities U.S. Bonds Int'l. Bonds Bonds Bonds U.S. Managed
equities equities Quality (large cap) (small cap) (emerging) (gov't.) (gov't.) (emerging) (inflation treasury Timber
(large cap) (small cap) indexed) (30 days to
2 yrs.)

±6.5 ±7.0 ±6.0 ±6.5 ±7.0 ±10.5 ±4.0 ±4.0 ±8.5 ±1.5 ±1.5 ±5.5
Estimated Range of 7-Year Annualized Returns
Note: These charts represents real return forecasts1 for several asset classes and an estimate of net value expected to be added from active management. These
forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ
materially from the forecasts above.
1
Real returns — long-term inflation assumption: 2.5% per year.
2 Alpha transported from management of global equities.
3 Alpha transported from management of global bonds.

Mr. Montier is a member of GMO’s asset allocation team. He is the author of several books including Behavioural Investing: A Practitioner’s Guide to
Applying Behavioural Finance; Value Investing: Tools and Techniques for Intelligent Investment; and The Little Book of Behavioural Investing.
Disclaimer: The views expressed herein are those of James Montier and are subject to change at any time based on market and other conditions. This is not an
offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative
purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
Copyright © 2010 by GMO LLC. All rights reserved.

Is Austerity the Road to Ruin? – July 2010 5 GMO

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