As you can see from Ireland, budget austerity doesn’t reassure financial markets if austerity doesn’t lead to growth:
The Moody’s agency cut Ireland’s credit rating Monday, citing the country’s swelling national debt, the unpredictable cost of its bank-bailout plans and its weak growth prospects for the next three to five years.
Shares on the Irish Stock Exchange slumped after Dietmar Hornung, Moody’s lead analyst for Ireland, announced that the New York-based agency was dropping its credit-worthiness rating one notch to Aa2. Moody’s previously cut Ireland’s rating to Aa1 from the top grade, Aaa, in July 2009 as Ireland plunged into its worst recession since the Great Depression of the 1930s.
To be clear, I don’t blame Irish policymakers. There are two paths to recovery for countries hit by a sharp negative shock. One, appropriate to small economies with floating currencies is austerity and currency devaluation. The other, appropriate to large economies that can borrow in their own currency is expansionary fiscal policy to bolster growth. New Zealand and Sweden fit the first model. The US and Japan fit the second model. Sometimes you get a country like the UK that seems to be an intermediate case. And then you have the sad case of the Eurofringe — small economies tethered to a German-dominated currency union. Citizens of such countries are, as best I can tell, just doomed. Austerity under these circumstances is self-defeating, but likely less self-defeating than any alternatives. Their only hopes of recovery are either substantial fiscal transfers from economically healthier states, which is not going to happen, or else monetary policy that’s geared to their needs rather than to the needs of Germany, which is also not going to happen.
If you read Jean-Claude Trichet’s recent interview with French newspaper Libération the paper keeps trying to press him on this point and his answers underscore the fact that the Euro is really a political project rather than an economic one. Which is fine as far as it goes, but the fact is that it doesn’t make a ton of sense economically and its architects aren’t doing what would need to be done to make it work.
The United States, however, is not Ireland. We can avoid this fate with fiscal and monetary expansion. People want to lend money to countries that are going to grow.