Grasping Reality on TypePad, by Brad DeLong

Kevin O'Rourke:

What do markets want?: [T]he question of what markets want is beginning to exercise people (see for example here, or here).... [M]arkets understand that governments face political constraints, and take this into account when assessing the credibility of their economic policies. (And, moreover, market participants tend not to believe in tooth fairies or negative fiscal multipliers.)

We’ve known all along that fiscal adjustment here would be contractionary, and that our economy thus needed substantial export growth if it was to avoid falling into the hands of the IMF. That in turn requires a buoyant European economy; hence my alarm regarding austerity measures in countries like the UK and Germany.... Ireland has no choice right now concerning what policies to pursue, but other countries do, and if those with fiscal space (as measured by the interest rates at which they can borrow) choose to embark on contractionary policies now, for what appear to be nothing more than ideological reasons, then that is profoundly irresponsible from the point of view of the fragile system that is the European economy.

And:

What do markets want?: With governments around Europe moving towards fiscal austerity, at a time when over-indebted households are still reluctant to spend, the danger is that Europe will move back into recession.   Why are European governments embarking on such a risky strategy? In peripheral economies such as Greece, Ireland or Spain, the governments have no choice: the markets have made it clear that otherwise they will no longer be willing to continue lending to them. Governments have thus had to cut spending and raise taxes at the worst possible time.... [I]t must have been utterly exasperating for the Spanish government when, late last week, Fitch downgraded Spanish debt on the basis that Spain's adjustment process will lower its medium run growth prospects. It seems a case of damned if you do, damned if you don't.   What, might Spanish politicians well ask, do markets want?   As it happens, the EMS crisis of 1992-1993 taught us a lot about what markets want.... The initial response of politicians was a macho one: get the fundamentals right and the problem would go away. The fundamentals concerned were low inflation, low deficits, and low levels of government debt. But speculation did not stop. The lesson of the EMS crisis is that low inflation, low deficits and low government debt are not, it turns out, enough on their own... if government policies are to be credible.... [F]ar from enhancing credibility, the 'responsible' and deflationary policies which governments thought markets wanted fatally undermined it.... This should not have been a surprise to the governments concerned, since it is a constant theme in 20th century economic history....   Markets want debts to be kept under control, but in the long run they also want tolerable levels of unemployment, since this is what democracy demands of governments. In our current circumstances, this means economic growth. Too much austerity at the wrong time will not make governments more credible, but less so.   Where will this growth come from?... Europe hopes that it will export its way to recovery.... [T]his could lead to US and Asian retaliation.... Those economies with fiscal room to manoeuvre need to use it now, for the good of the European economy. Furthermore, we should be asking whether the European Union as a whole should embark on a growth and investment strategy. Major European investments in new transportation and energy infrastructures are needed in the long run anyway....

If the EU turns itself into a mechanism for imposing asymmetric and deflationary adjustment on the continent, it will be seen, rightly, as one of the causes. And the markets won't like that.