Investor Silver Lining to the Age of Austerity

By: Hans_Wagner

According to some analysts and David Cameron, the new prime minister of the United Kingdom, the “Age of Austerity” is upon us. If the cuts promised by many European countries actually take place, investors fear it will lead to another recession in several of those countries. The age of austerity is what has worried the markets in the last month causing anxiety as volatility ruled the days.

A closer look shows these cuts might not be as severe as originally thought. With the right approach, the austerity programs might achieve some of the government’s goals and contribute to economic growth. If true, the sell off in the market is an over reaction.

Proposed Cuts

In addition to Greece, Spain, Portugal and Ireland have cut spending to meet demands of investors and to obtain interim funding. Germany, the strongest European Union member, announced they intend to save 80 billion euros by 2014, setting an example of budgetary discipline according to Chancellor Angela Merkel. France indicated they would cut their deficit by reducing tax exemptions and freezing much of the government’s spending starting next year. Italy committed to cuts of 25 billion euros from its budget by 2012.

Investors, especially those in the U.S. worry that these budget cuts, while necessary, will cause much of Europe to experience little or no growth, and maybe another recession. With the recovery struggling to survive, higher taxes and cuts in government spending could weaken the recovery, they believe. On the other hand, long-term sustainable growth will be worse if their budget problems are not resolved.

Take a more in-depth look and we find the outlook is better than many believe. The worry these new austerity programs will cause a major economic blow to the global economy is overstated. Yes, Greece’s budget cuts amount to 7 percent of GDP for this year. They expect their cuts to be 4 percent next year. Yet, Greece is a small country of 11 million people and their affect on the global economy is minor.

Spain, Portugal and Ireland intend to cut their government budgets by 2 to 3 percent over the next two years. While important, these are not drastic cuts. The GDP of these five countries amounts to one-fifth of the entire euro zone.

Germany is the economic engine for The European Union. Their 80 billion in cuts take place over a four-year period, with most of the savings coming in 2013 and 2014. The net affect on Germany’s GDP is less than 0.5 percent. Hardly a severe cut.

Another positive, the fear of higher government budget deficits tends to encourage higher consumer saving. Higher private savings, according to Christiane Nickel and Isabel Vansteenkiste of the European Central Bank, accompany rising budget deficits in countries with high debt levels. For the record, U.S. consumers are saving more as they see their government incur record deficits and they are paying down their debts. While a higher savings rate lowers consumer spending, an important driver of any economy, it provides private investment capital.

Least and Most Harmful Cuts

The type of austerity measures a government undertakes can make an important difference to its economic future. Cuts in welfare payments or government wages are more likely to deliver better long-term results than those based on tax increases or cuts in public investment according to a study for the National Bureau of Economic Research by Alberto Alesina of Harvard University and Roberto Perotti of Milan’s Bocconi University. Taxes on company profits or consumer spending were the least harmful taxes.

Most of the austerity programs announced by European countries include salary cuts and lower entitlements, the type of cuts Alesina and Perotti found were the least harmful. Smaller cuts in public investment are in the works as well. This indicates that cuts by these European nations will not be as hurtful as many investors and analysts expect. If true, the dire consequences many expect from Europe may not be real. For example, the French government announced they intend to raise the retirement age from 60 to 62 by 2018.

In the U.S., the government stimulus program has spent more on payments to state and local governments to help them maintain their level of service and to keep teachers employed. At the federal level, salary increases continue and many agencies are hiring additional people, expanding salaries paid to government employees, the opposite of the best way to proceed. Payments for unemployment insurance keep expanding as do payments for other social welfare programs including Medicaid and the new healthcare program. 2010 and 2011 will see more spending on infrastructure projects.

The underlying strength of the U.S. economy remains positive, though it must overcome the negative consequences of the high deficit.

The Bottom Line

The Age of Austerity has spawned significant budget cuts by many European governments. Investors fear the economic recovery that is just underway will fail. A slow down by the European economies threatens the global economic recovery as we are all connected. If the austerity programs focus on lower entitlements and cuts in government pay, they have a greater chance of reducing their deficit and encouraging economic growth. So far, most of the European programs fit this model.

Investors need to look deeper into the European austerity programs that are underway. When they do, they will find that the proposed cuts are better than originally thought. This silver lining indicates the markets overreacted when they sold off in May. There are some good opportunities in the market and we might see a rally, once Mr. Market understands the situation.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2010 Hans Wagner

If you wish to learn more on evaluating the market cycles, I suggest you read:

Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis is an excellent book on how to predict macro moves of the market.

Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling.  One of the best, easy-to-read, study of stock market cycles of which I know.

The Disciplined Trader: Developing Winning Attitudes by Mark Douglas.  Controlling ones attitudes and emotions are crucial if you are to be a successful trader.

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