Friday, July 30, 2010

>Is Austerity the Road to Ruin? - JAMES MONTIER

Let 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 would be truly pointless), but I do think that understanding the macro backdrop can, on occasion, help inform the investment process. For instance, those who understood the impact of a bursting credit bubble stayed well clear
of the value trap opportunities offered in financial stocks during 2008. Those who focused purely on the bottom-up tended to plow in and repent at leisure, as the deteriorating fundamentals generated a permanent loss of capital. So why share this confession now? I think we are seeing
a very worrying trend around the world: the rise of the Austerians. This breed is the latest incarnation of what used to be called the deficit hawks, a group set upon reducing what it sees as the government’s profligate spending.

The power of the paradox of thrift
The Austerians either ignore or dismiss the paradox of thrift. This paradox (which appears first in the Fable of the Bees1) was popularized by John Maynard Keynes inThe General Theory of Employment, Interest and Money. He wrote:

For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption 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 consumption will so affect incomes that the attempt necessarily defeats itself. It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment.

In essence, the paradox of thrift is a fallacy of composition. Whilst it may be perfectly rational for one household (or section of the economy) to save more, if everyone tries to save more, total income is lowered. If you aren’t spending, then neither are the people who depend upon
you for their source of income. Firms won’t invest if there is no demand for their products, and we end up in a nasty downward spiral.

To read the full report: Is Austerity the Road to Ruin?