Cross-posted from the New Deal 2.0 blog

by Marshall Auerback

Governments across the globe are headed for a disaster entirely of their own making.

Though capital markets remain strong, the global economic backdrop continues to deteriorate as fiscal retrenchment takes hold. Commodity markets have rallied in tandem with the fall in the dollar even though there are signs that growth in the emerging world is slowing. Japan’s economy is in the soup, the U.S. economy has failed to pick up as many thought (with a mere 2% growth rate expected to be released for Q1 shortly), and the European economy is overdue for its own slowdown. The U.S. stock market has also rallied despite the threat of a very high gasoline price, disappointing economic growth data, and a fairly mixed earnings picture.

The new theme in the market seems to be that the Fed, unlike other central banks, will stick with super easy money policies, hence the tendency to push the weak dollar, rising equity prices, and soaring commodity prices. But the news that real GDP growth has fallen sharply in the first three months of 2011 is evidence that the current policy mix, with its emphasis on public spending cuts, is not working. If gasoline prices spike as high as they did in June 2008, they will further weaken an already feeble economy. Consumers did not show up at Walmart at the end of the month because they ran out of money. House prices are still falling.

At the same time, the political debate is focused on the public debt limit, which expires in a few weeks. Conservatives are once again threatening not to extend this limit, even though no less a figure than Warren Buffett has said the failure to do so would be the “most asinine act” the U.S. Congress has ever committed.

The evidence of an increasingly imploding euro zone (which continues to embrace fiscal austerity with the zeal of a religious fanatic) does not seem to have shifted the debate much in this country. Many European governments are facing a fiscal crisis due to their failure to advance public purpose and raise the funds needed to maintain existing programs. Only the interventions of the ECB are saving the whole system from total meltdown, but the underlying solvency problem for the individual member states is getting worse as the days go by. The Euro bosses are failing, and with any luck, so is political resistance to rational economic policy.

Last week, we got a whopping negative surprise with real retail sales down 2.1% in Germany, Europe’s largest economy. Since analysts had been hoping for no change, this is troubling and suggests that the problems of the euro zone are now extending beyond the periphery problem children, like Ireland, Portugal and Greece, into the core countries. The stronger euro, slowdowns in some emerging economies, and fiscal tightening could all add up to weaker-than-expected German exports, and weak German household spending could lead to a significant disappointment in the rest of Europe.

While Germany looms on the horizon, the euro disaster de jour is an eight percent year on year decline in Spanish retail sales. This in a country with a 21.3% unemployment rate. Their construction industry is probably still in decline, and there will be further government cutbacks. The Spanish trade account is now deteriorating and should continue to do so at this exchange rate, short of a disastrous decline in domestic demand. Spain was the domino that wasn’t supposed to fall in Euroland. So much for that idea.

Meanwhile, what is happening in Ireland makes a Samuel Beckett play look like a Restoration Comedy by comparison. The issue being faced there is akin to the problem faced by Iceland last year: should voters reject a taxpayer bailout of foreign creditors? Like Iceland, it faces a crushing debt because its government took on the liabilities of its oversized banks, who had lent indiscriminately throughout Euroland. However, unlike Iceland, Irish bank liabilities are denominated in the currency used in Ireland, the euro. Like every other country in the euro zone, the “Celtic Tiger” abandoned its sovereign currency when it joined the Euro. Effectively, it became like a U.S. state within Euroland, which means that it has little domestic policy space to use monetary or fiscal policy to deal with this crisis. The Irish economy continues to deflate into the ground, and default seems like an increasingly likely option unless debt relief is provided by the ECB or the EMU through some other entity. That is actually in the EMU’s interests, since much of the bank debt guaranteed by Ireland’s government is held externally by EU banks, but huge political opposition in some of the wealthier EU states (e.g. Finland and Germany) makes this an increasingly unlikely scenario. Default and possible expulsion from the euro zone (and all of the attendant systemic problems this would pose for Europe) are increasingly likely possibilities.

In Asia, things are not much better. Japan’s industrial production is down far, far more than anyone imagined, as is household consumption. Destructive IMF-style thinking still predominates in Tokyo, where the government is in thrall to a gaggle of deficit terrorists who think they can’t afford to fund a proper reconstruction in the country.

The economic data coming out of China is so bad it is hard to assess what is happening, but there is enough evidence to suggest that the Chinese economy too slowed in the fourth quarter of last year and has slowed further in the first quarter of this year. It seems that there are two reasons to expect further slowing:

1. The Chinese keep tightening monetary policy in response to rising inflationary pressures. Unfortunately, hiking rates via direct rate rises is the wrong way to go about it, because the resultant rise in interest income for savers ADDS to aggregate demand through the interest income channels, making their inflation that much worse. In response, Beijing is also beginning to deploy credit controls, which do slow demand, as do automatic stabilizers that work through higher nominal growth, including reduced transfer payments and higher tax receipts. In general, this type of policy response constitutes a significant tightening of fiscal policy and leads to a very hard landing.

2. The ratio of Chinese fixed investment to GDP is so high it is very difficult to sustain. A rising real effective exchange rate is surely squeezing many companies and that should curb their fixed investment. There has been a big shift in the composition of Chinese fixed investment from profitable industries that can self-finance to local government projects which are highly debt-dependent and have minimal ability to self-finance. This shift to more debt-dependent sectors should have an adverse impact on fixed investment, though with some lag.

All in all, not a pretty global picture. It’s only made worse by the fact that virtually all economic debates remain heavily skewed to further cutting government spending at a time when growth rates are falling and unemployment claims are rising. In short, the human tragedy we are now experiencing is totally self-inflicted policy stupidity. But then again, when have the neo-liberals ever let facts get in the way of a good theory?

Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.

**For more on why cutting spending during an economic downturn is a bad idea, check out Arjun Jayadev and Mike Konczal’s working paper, “The Boom Not the Slump: The Right Time for Austerity.”