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No virtue in austerity just for the sake of austerity

THE United States didn't go over the fiscal cliff.

That's good news, right? Well, the stock market seemed to think so: the FTSE rose above 6000 for the first time in 18 months. And it was surely a good thing to see investors here, and in the rest of the world, celebrating an increase in taxes for the rich – or at any rate those earning more than $450,000 a year.

This was a victory for President Obama, of that there is no doubt. Refusing to blink as the Tea Party Republicans took America to the brink, he managed to avoid any big cuts – at least for now – in federal spending on tax credits to the low-paid or welfare to the long-term unemployed, who stood to have their benefits cut completely. The US is a slightly fairer country as a result. The Republicans have been left divided and confused, with the budgetary super-hawk, Paul Ryan, voting with Mr Obama.

But isn't it just a little odd that hedge fund managers and other stock market money men here should find this all so positive? Presumably, they believe that these measures, the avoidance of deep spending cuts, mean that the world economy is now in better shape. But that isn't the economic logic they have been applying on this side of the pond. In the UK, the Coalition decided to go over its own voluntary fiscal cliff in 2010 when the Chancellor, George Osborne, announced that he was going to put through the deepest spending cuts in half a century and eliminate the deficit in five years. "Cheers," said the stock market suits, "just what we need to put the country on course for recovery." Unfortunately, the UK economy went into a double- dip recession which looks like lasting well into 2013. So why is a fiscal cliff good here but not in America?

In Europe, they went even further over the cliff and plunged Mediterranean countries like Spain, Greece and Portugal into crushing economic depressions. Why? The US is in just as serious a debt hole as the eurozone. America has a £16.4 trillion debt, and its annual deficit – the amount the Government has to borrow each year – is nearly 9% of GDP. That's higher than any eurozone country's deficit and three times the 3% ceiling in the EU "stability pact". Yet the European Central Bank and the German bankers were yesterday also celebrating the fact that America had decided not to do what they've been doing. Perhaps they could learn something.

The fiscal cliff is shorthand for austerity. It is the debt problem that has afflicted all the advanced industrialised countries to some degree – partly as a consequence of the rise of the East and the South. The emergence of technically-advanced, low-wage economies like China and South Korea (though the land of Gangman Style isn't so low-wage any more) has undermined the finances of Western states, which are having difficulty financing their health and welfare bills and high unemployment ratios. At least, that's the theory. We all have to pay ourselves less to remain competitive, say Tory deficit hawks. We can't go on borrowing against the future, must cut our cloth, spend within our means, tighten our belts and generate a whole raft of new cliches to justify cutting the state.

There is of course some truth in this. Western consumers – encouraged by rapacious and short-sighted bankers – borrowed far too much in the early 2000s and were duped by the house price bubble into thinking debt never needed to be repaid. Our governments went along with this binge because politicians are mostly in the pockets of the bankers. Some states, like Greece, simply lied about their finances and – advised by Wall Street banks like Goldman Sachs – hoped the EU wouldn't notice, which of course they did. However, the "tighten our belts" response to this debt problem in euroland got out of hand and made repayment more difficult.

Economics is full of paradoxes, and one of them is that cutting government spending in the wrong way increases government debt. The oldest rule in public finances is that you need growth to pay down debt – or as President Obama put it yesterday, you can't cut your way to prosperity. This is because of what economists call the "fiscal multiplier" and the rest of us would call common sense. If your job pays too little, you won't be able to pay off the mortgage early – you need a raise, a new job, or a longer mortgage. If you leave your job, or go part-time, then your debts are going to increase because you can't pay the interest on it. Crudely speaking, America is going for the better job option; we are going part-time.

America has been spending for employment growth while we are cutting for recession. America has been growing between 1.5% and 2% over the last three years, whereas the British economy has actually declined. The stock markets like the Obama solution because – in spite of themselves – they realise that growth pays down debt, and leads to higher profits as the economy expands.

Of course, America is in a privileged position because it is the world's leading economy, greatest exporter and has a global reserve currency, the dollar. It isn't so vulnerable to the sovereign debt crisis that afflicts eurozone countries like Portugal or Spain which start getting into a debt spiral when investors lose confidence. The world knows that America will always pay its sovereign debt – even if it's in devalued dollars. Greece has shown that eurozone countries can effectively default by writing down their debts unilaterally, forcing investors to lose up to 90% of the value of their government bonds. Nevertheless, even the International Monetary Fund now accepts that because of the "fiscal multiplier" the cuts in the eurozone, and in Britain, are making recession worse. The eurozone – taken together – is much bigger than America and could have equal currency clout, if it got its act together

It sounds technical, but there really is a simple lesson here for Britain and the eurozone: you don't have to go over the cliff. There is no virtue in austerity for austerity's sake. Governments don't have to make spending cuts that plunge the economy into recession. Just say no.

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