Investment Commentary – October 2012

Paradox of Thrift

Now well into its fourth year, the European financial crisis continues to be the predominant dark cloud hanging over the investment world. While markets were recently placated by further accommodative monetary policy from the major central banks, a clear plan on how to resolve the region’s structural issues remains elusive. Last month, despite implementing aggressive austerity measures, the Spanish government announced that their fiscal deficit will miss targets for 2012, while also revising last year’s deficit upward from 8.9% to 9.3% of GDP. Spain joined a long list of Eurozone nations that have revised their debt and deficit targets higher despite draconian tax increases and spending cuts. Debt and deficit levels are also current “hot button” issues in the US with both political parties divided and the fiscal cliff looming. What is at issue is what many noted economists have referred to as the ”paradox of thrift”: the more that deleveraging and austerity are used to combat rising debts and deficits, the harder it becomes to reduce these sums due to their deleterious effect on the economy. The question of how much austerity to push – and how fast – lies at the heart of the developed world’s current economic woes.

TOP: Public Debt-to-GDP ratios – Canada (1994 to 1997) vs. Eurozone and US (2008 to 2011)                                                                                                                                                                                                                                                                       
BOTTOM: Fiscal deficit as a percentage of GDP – Canada (1994 to 1997) vs. Eurozone and US (2008 to 2011)


Source: Bloomberg |

A recent paper from the MacDonald-Laurier Institute, an Ottawa-based public policy think tank, suggests that those countries currently mired in fiscal crisis could learn from Canada’s experience in the 1990’s. The graphs compare Canada’s public debt and deficit figures from 1994 to 1997 to current figures for the US, Spain, Italy and Greece. Not that long ago the Canadian economy faced similar fiscal strains, during which time Federal bonds lost their AAA status and the Wall Street Journal dubbed Canada an “honorary member of the Third world”. However, in 1995 the Canadian government focused on reining in entitlement spending, turning a $32 billion dollar shortfall into a $2.5 billion surplus in just 2 years. Federal spending declined from 22% of GDP to 15% in 2004, leading to 11 consecutive fiscal surpluses. These savings were used to pay down public debts, which went from over 100% of GDP in 1996 to a historically-low 67% in 2007. Most importantly, there was no “paradox of thrift”. The Canadian economy avoided a recession and outpaced all G7 nations in GDP growth in the decade following the reforms.

Admittedly, it is simplistic to suggest that the Canadian austerity experience in the 1990’s is an exact blueprint for today’s budgetary debacles. For instance, a significant increase in exports to the fast-growing US and Chinese economies helped offset the fiscal drag in Canada. Currently, with the world economy slowing, relying on an export-led boost to cushion austerity measures is a less-realistic option. However, one takeaway is the importance of monetary policy. A recent study by the International Monetary Fund concluded that while tax increases and budget cuts help, the common theme running through each successful austerity program – including Canada in the 1990’s – was easier monetary policies. This fact could be the silver lining in the dark investment clouds, as central bankers today remain firmly committed to ultra-accommodative monetary policies. Although some pundits and politicians paint a gloomy economic picture, past episodes suggest that today’s fiscal issues are not insurmountable.

At T.E.I.C. we continue to take a long-term view. Although equity prices are down for many European companies, the majority will weather this storm and come out of it intact. It is essentially a matter of when, not if. When the tide does turn, those who maintained exposure to European stocks will finally be rewarded for their patience.

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