OTTAWA — Beware a repeat of the 1870s and 1930s depressions.
The morning after leaders of the big economies called for bitter medicine to cure the world’s ills, many analysts said the prescription will lead to slower growth and at least one prominent economist said it could trigger a depression.
The alarming analysis came from Nobel laureate Paul Krugman, who argued in the New York Times that by turning on a dime from stimulus to restraint, governments are threatening to turn a recession into a full-fledged depression.
“We are now, I fear, in the early stages of a third depression,” Krugman writes. “And this third depression will be primarily a failure of policy. Around the world . . . governments are obsessing about inflation when the real threat is deflation.”
The other two recorded depressions — lengthy and deep economic contractions — occurred in the 1870s and the 1930s.
Even some economists who agreed with the G20 consensus, such as Craig Alexander of TD Bank and Brian Bethune of IHS Global Insight, wondered if countries such as Germany were taking austerity too much to heart.
Of course the G20 leaders don’t see it that way.
Spooked by Europe’s debt crisis, leaders in Toronto, with the possible exception of Japan and the U.S., believe spending cuts to at least halve deficits in the developed world by 2013 are essential to avert, not cause, a second financial meltdown.
That policy was aimed at preventing what has laid low Greece from striking other indebted countries, and was pre-endorsed by the International Monetary Fund.
On Monday, the Bank of International Settlements added another official blessing, stating: “The first and most immediate challenge is to make a convincing start on reducing budget deficits in the advanced economies.”
Krugman’s response is that by withdrawing stimulus now, when the recovery has barely begun, countries are repeating the mistake made in the 1930s when government’s started tightening at the first sign of progress, causing the economy to turn south again.
There is only the slimmest of evidence that Europe, the world’s largest market, has escaped recession, and in North America, both the U.S. and Canada are in the midst of a pull-back just months after strong rebounds that began last fall.
All the fresh data coming out of Canada suggests April’s growth, when it is revealed Wednesday, will fall to about 0.1 per cent from 0.6 per cent in March. Similarly, second quarter growth is now expected to be less than half the 6.1 per cent pace in the first three months.
There’s little doubt that the recovery, even in North America, remains fragile, says Bethune. But it is going too far to say fiscal tightening will cause a depression.
He says the damage of government restraint can be offset by stimulative monetary policy that keeps interest rates as low as possible — a policy that Canada should return to. Bethune believes the Bank of Canada’s signals it would raise rates this spring, followed by a 25-basis point hike in June, caused real rates to rise by one per cent overall and exacerbated the slowdown.
Besides, added Alexander, Europe’s weak sisters had little choice, although he questioned if Germany too eagerly embraced the policy.
“The fiscal austerity ultimately had to come,” he said, since markets were not going to finance sky-high sovereign debt much longer.
“In the case the case of Greece, Portugal, Spain and Ireland, it had to happen now. In the case of Germany, maybe the government did not have to impose quite as much austerity in the near term.”
Krugman’s argument is that fiscal restraint is correct when economies are strong. But, under these circumstances, restraint actually causes the problem you are trying to solve, since by slowing growth, governments reduce their tax intake and deficits rise rather than fall.
And he has the example of the 1870s and 1930s to back him.