"Free Market" Politicians Call for Austerity and Cuts While Financial Markets Call for Keynesian Stimulus and Jobs

09/28/2011 09:21 am ET | Updated Nov 28, 2011

There's a bizarre, otherworldly nature to the extreme disconnect between politicians in the US and Europe who are pursuing policies of austerity, cuts, and deficit reduction, and financial markets in the US and around the world which seem to be begging governments to stimulate the economy, create jobs, increase aggregate demand, and take aggressive steps to prevent sovereign debt defaults in southern Europe in order to avoid a double dip recession or even a depression.

In US stock markets, the Dow is down nearly 16% from its peak in late April (about the time Obama and Republicans started discussions of tying an increase in the debt ceiling to deficit reduction) and despite a small relief rally during the past two days, last week the Dow suffered its worst one-week decline since the financial crisis in October 2008. Approximately half of this decline has come since Congressional Republicans and Obama reached their 11th hour debt reduction deal, which according to Republicans, was supposed reduce market uncertainty.

On Monday, no less an authority than the Wall Street Journal announced in a front page headline: "Pivot Point: Investors Lose Faith in Stocks". According to the Journal,

"Across the financial markets, a sea change is taking place. Investors are abandoning the time-tested 'stocks for the long run' optimism that dominated since the late 1980s. Instead, there is the widening belief that the mess left behind by the housing bubble and financial crisis will be a morass to contend with for years."

The Journal cited the concerns of many large investors including the $650 million Heritage Financial Services, which

"focused on the potential drag on an already weak economy from reduced government spending. When [Heritage President] Mr. Bean and the rest of the firm's management committee met in the third week of July, they discussed the prospect that deficit reduction could raise recession risk. Heritage pared back its expectations for economic growth and corporate profits for the next several years...[and[ reduced stock holdings."

This is consistent with the trend reported by The Journal among investors worldwide which "in a historic retreat" in the three months through August pulled $92 billion out of stock funds in developed markets and another $25 billion in the first three weeks of September.

At the same time as markets having been fleeing stocks, they have been pouring money into loans to the US Treasury. Markets are now willing to lend massive amounts of money to the US government for 10 years at less than 2% interest, the lowest rate since the 1940's and down a third since early August.

Putting together the collapse of stock prices and the growing appetite to buy US government debt, what do the markets seem to be saying? Far from adding market confidence as Republicans and other austerity-advocate claim, budget cuts are making markets fear slower economic growth. At the same time, the willingness of markets to lend the US government billions of dollars virtually interest-free (after deducting the interest rates from the rate inflation), indicates that they have little concern that the Federal debt is a serious problem which, in the foreseeable future, makes it less likely that the US government will pay them back.

As Bill Gross, founder and manager of the Pimco Total Return Fund, the world's largest mutual fund (hardly a leftist), writes in a Washington Post column entitled "America's Debt is Not its Biggest Problem",

"Washington has been operating the past few months under the assumption that the United States and our euro-zone economic trading partners are experiencing a debt crisis that must be resolved by exorcising excessive spending in the near term. To Republicans, and even many co-opted Democrats, the debate starts with spending cuts and how much must be done to appease voters and the markets, both now and in November, when the 'Gang of Twelve' committee that resulted from the debt-ceiling deal potentially follows through with its mandate.

...It is not the debt, however, but the lack of global aggregate demand that is at the heart of the crisis...An anti-Keynesian,budget-balancing immediacy imparts a constructive noose around whatever demand remains alive and kicking. Washington hassles over debt ceilings instead of job creation in the mistaken belief that a balanced budget will produce a balanced economy. It will not...A 21st-century Keynes would have recognized this and sounded the alarm, pointing out that policymakers from a fiscal perspective are pointing us towards recession and the destructive 1930s."

In other words, markets seem to be begging the US government to borrow more money and stimulate the economy, not to cut spending and reduce the deficit, at least in the short to medium range, in order to avoid a double-dip recession or perhaps worse.

Economist Nouriel Roubini -- an NYU business professor and financial consultant, who was one of the few economists to correctly predict the collapse of the US housing boom, the financial crisis of 2008, and the great recession -- warns of an even more serious economic crisis if governments in Washington, Berlin, London and Tokyo do not change their austerity policies, stimulate the economy and take decisive steps to prevent sovereign debt default in weaker European countries.

"The latest economic data suggests that recession is returning to most advanced economies, with financial markets reaching levels of stress unseen since the collapse of Lehman Brothers in 2008...

The risks ahead are not just of a mild double-dip recession, but of a severe contraction that could turn into Great Depression II, especially if the eurozone crisis becomes disorderly and leads to a global financial meltdown. Wrong-headed policies during the first Great Depression let to trade and currency wars, disorderly debt defaults, deflation, rising income and wealth inequality, poverty, desperation,, and social and political instability that eventually led to the rise of authoritarian regimes and World War II. The best way to avoid the risk of repeating such a sequence is bold and aggressive global policy action now."

As markets warn of the risk of double-dip recession or even depression, politicians in Washington and Bonn -- who claim to believe in "free markets" -- fiddle while Rome may be about to burn. The German government hesitates to approve even a too-small Greek bailout. In Washington, almost all the action is about whether the Congressional Super-Committee will agree upon another $1.2 trillion in budget cuts or whether they will be imposed by fiat. A year too late, Obama proposes a too-small jobs package which has no chance of passing Congress in the hopes that it will improve his reelection 14 months from now. There seems to be an almost total disconnect between the political debate and the economic reality.

As financial markets deteriorate, 14 months could turn into a lifetime. Without decisive government action, by November 2012 we're likely to be in the midst of a double-dip recession, if not a depression, which could further undermine the economic fortunes of tens of millions of people. Who knows what the political fallout will be. If by Election Day the economy and the jobs situation has turned substantially worse and the only political alternative to President Obama is not FDR but Rick Perry or Mitt Romney, the political outcome could become quite bizarre and frightening.