All That Glitters / To Cut or Not to Cut

Budget cuts are good, but not when they depress investment, and they rarely encourage growth in the short run.

When a person, household or company stumbles into debt - the kind of debt that hampers their functioning and threatens to reduce them to bankruptcy - the natural reaction is simple. They cut back. The logic is clear. Reduce costs and there is more money in the bank account to repay debt. After a while, the budget can be rebalanced, and a whole new chapter can begin.

But does that work for countries, as well? Until this week, one would have categorically said yes. When a country defaults, there is one remedy prescribed by the global economic institutions, the rich nations and the credit rating agencies: reduce public spending. How? By cutting the budget, canceling public services, firing state workers, selling state assets and canceling activities. Anything to bring down spending.

It's the same this time around. In order to get help from the rest of Europe, Greece was forced to take a machete to its bloated public sector. To contend with its crisis, Britain also sent civil servants home and raised the prices of dozens of services, and it did not shy away from tripling tuition for higher education. The public took to the streets in frustration and anger, but the economic logic behind the move was clear: It was the only way to get out of the swamp of debt.

But there are other opinions making the round. Explaining its unexpected debt downgrade of Italy, credit rating agency Standard & Poor's wrote last week, "More subdued external demand, government austerity measures, and upward pressure on funding costs in both the public and private sectors will, in our opinion, likely result in weaker growth for the Italian economy."

That's the bizarre part. The credit rating agency explains that it downgraded Italy's credit rating (in part ) because of its cuts to budgets and services, which the agency expects will dampen growth (and tax revenue ).

Didn't Italy adopt austerity measures - measures which cause citizens so much pain - precisely so it could meet its liabilities and avoid a downgrade? In other words, are the economists at S&P changing their tune and saying that austerity isn't the remedy for rising debt, and that, if anything, it can make things worse?

S&P wasn't the only one singing that tune. The International Monetary Fund explicitly said last week that the big countries must avoid overly onerous budget cuts in the short run. "The global economy is slowing," the report stated, which can only be cured by households and business stepping up demand. The IMF applauded the United States for its plan presented by U.S. President Barack Obama to stimulate the economy and create jobs.

Cuts are good, to a point

The message is the same: Government budget cuts are good, but not when they reach the point of depressing investment by people and companies, and there aren't many cases in which government cutbacks encourage growth and investment in the short run.

What does all this mean? In the debate between the conservative view, which demands budget discipline and low taxes across the board, and the view that times of emergency require expansion to stimulate economic activity, the latter argument is beginning to prevail.

If we bring this same debate to Israel, then the position of Prime Minister Benjamin Netanyahu and his budgets department weakens, while the claims of people urging budget expansion and spending more on the weak gain ground. One reason is that while the rich save their money in the bank, the poor spend it, which stimulates the economy.

Ahead of the debate on the Trajtenberg Committee's recommendations versus those of the Spivak Committee (representing the protest movement ), the latter recommendations are gaining ground. Not that the case is closed - a raucous discussion lies ahead.

Last week, I wrote that the shekel was weakening against the dollar for two reasons: Speculative money leaving Israel and developing markets for fear of a global financial crisis, and Israel's transition to a current account deficit. More dollars are leaving Israel than are entering. But there's a third reason, one just as important: fear of geopolitical events that will wound the Israeli economy and its ability to repay debt.

That risk is getting worse by the day, as one may conclude from the soaring price of credit default swaps - a sort of insurance against Israel defaulting on its bonds. Last Thursday, credit default swaps reached their highest price in a long time, 192 points. The credit rating agencies may have upgraded Israel, and the Bank of Israel may opine that the economy will grow by no less than 4.7% this year, but the markets are saying that nothing is forever, and that a global economic crisis and uncertainty about Israel's safety matter more.