Restraint or stimulus? Markets and governments swap roles

There was a time, not so long ago, when politicians were profligate and the markets begged for restraint. Not any more.

Now it is politicians - on both sides of the Atlantic - who demand fiscal restraint and spending cuts. While the financial markets seem to be looking for stimulus.

I was especially struck by the reversal of roles in the US, where I spent several weeks during the summer. There, the market folk on Wall Street are all fretting about the possibility of a double-dip recession.

Indeed, most independent economists I have spoken to think there's a decent chance the economy is already contracting.

Fed's balance sheet

This has many looking to the Federal Reserve for yet another round of quantitative easing to support growth in the next month or two.

In addition, or instead, we might well see a strategic effort to reshuffle the central bank's balance sheet - nicknamed "Operation Twist," after a similar effort in the 1960s. That would involve the Fed selling short-term bonds on its balance sheet, and replacing them with longer term debt, so as to push down long-term interest rates even further.

On its own, that kind of operation could provide some support for the economy, without expanding the Fed's balance sheet, thus avoiding the complaints of the Chinese and others who say the Fed is fuelling bubbles in commodities and emerging markets every time it injects more cash into the economy.

'Recovery threatened'

But rates are already extremely low. And the talk in Washington - and across Europe - is all of fiscal austerity. This has many on Wall Street extremely concerned.

To cite just one example - a recent report by economists at Bank of America/Merrill Lynch says that "while fiscal austerity could help the long-run outlook, near-term fiscal consolidation threatens the recovery in developed economies".

They consider the argument - put forward by many Republicans and sometimes by George Osborne - that fiscal tightening will support growth by increasing confidence.

The economists conclude that this effect can operate in some conditions, especially when high fiscal deficits are already causing a crisis of confidence, as in Greece. But looking at the US and other major European countries, they note that

"Interest rates are already quite low, signalling limited market pressure to reduce deficits. As a result, near-term fiscal austerity would do little to lower rates. Moreover, companies are flush with cash. Investment is low because of a lack of confidence in the recovery - not because government borrowing is crowding them out."

So, there might well be plenty of support on Wall Street, if President Obama announced a push for some form of short-term fiscal stimulus for the economy when he addresses Congress on Thursday.

But everyone in the markets also knows that he will struggle to get any such steps through Congress - unless or until the recovery has clearly ground to a halt. In the recent negotiations with Republicans over the debt ceiling, Mr Obama was actually arguing for spending cuts and tax rises not dissimilar to Mr Osborne's in the UK.

'Fed up' bankers

The debate in the eurozone is somewhat similar: at a meeting of central bankers, business people and economists at Lake Como in Italy last weekend, everyone was agreed that the crisis economies on the periphery needed to cut spending and restructure their economies.

There was also a clear acceptance - at least by most of the private sector participants - that there needed to be some form of stimulus to offset the negative effect of all this austerity. But it was far from clear where that growth was going to come from.

For their part, the central bankers at the conference were clearly and volubly fed up with being the 'stimulators of first resort'. That seemed to put the onus on the politicians.

The economist, Nouriel Roubini, for example, called for fiscal stimulus in Germany. The new head of the IMF, Christine Lagarde, has been using not very coded language to call for the same thing.

But there is no mood for that in Germany, or France, where President Sarkozy was talking again today of a constitutional amendment to require governments to balance the national budget.

Bond markets

As we know, the political debate is rather different in the UK. But the bond markets are raising alarm about the economy, even if many City economists are not.

In my last post before going on holiday, I noted that we were reaching the point when low government borrowing rates were cause for fear, not jubilation. That is even more true today.

It is fear that explains why the interest rate on German government borrowing has now reached an all-time low, and the cost of borrowing for the UK and US governments is now lower than it has been for 60 years.

In the past few weeks, the yield on a 10-year US treasury bond has been regularly dipping below 2%. We should not forget to be astonished.

As I described in that earlier post, in normal times, a fall in bond yields would be considered good news - a sign that the UK and US governments were both considered safe bets.

Private investors would also usually consider it good news - indeed, essential - that politicians were committed to reducing budget deficits, especially when these have been at record high levels.

That is still true, when investors consider the longer term.

But short term, it is not good news that the major advanced economies are expected to need record low interest rates for years to come. Or that, almost exactly three years after the collapse of Lehman Brothers, investors around the world are still so afraid.