Why all signs point to chaos

You don't have to look far to find evidence that the glue that binds us together is losing its grip. Blame the years of economic turmoil and hardship. The volatility. The booms and busts. The persistent joblessness. The increasingly narrow path to financial independence.

For the vast majority of us -- dare I say, the 99% -- the social contract seems like a raw deal these days. Witness the anger shown in polls toward both President Barack Obama and House Republicans; depending on your political bent, you likely hate one and are disappointed by the other. Look at the ongoing, evolving natures of the Occupy Wall Street protests and the earlier Tea Party movement.

This isn't happening just here at home.
The most acute examples of popular rage can be seen overseas. Earlier this year, Arab Spring movements raged against despots across the Middle East and North Africa. More currently, a backlash against Vladimir Putin's shenanigans in Russia has erupted, and China is facing outrage over the less-serious problem of falling condo prices.
But above all, the unrest that has economists the most unsettled is in Europe -- the consequences of which will reverberate throughout the global economy and could very well pull the United States down into a new recession in 2012.
Frighteningly, to some economists, a new recession is the upside. How bad could the downside get?
Well, a pair of economists working in Spain have looked at the overriding issue in Europe -- austerity being forced on unwilling, overburdened populations -- and ranked the odds of various forms of unrest. And all signs point to chaos.

The chaos theory

Jacopo Ponticelli and Hans-Joachim Voth of Universitat Pompeu Fabra in Barcelona, have studied the social impact of government budget cuts in Europe since 1919. They found that "austerity has tended to go hand in hand with politically motivated violence and social instability" and revealed a strong link between the severity of budget austerity and the level of popular discontent.
They used this data to create a chaos metric representing the sum of events including assassinations, attempted revolutions, strikes, riots and demonstrations that occur per year.
The evidence finds that the deeper the budget cuts, the more severe the chaos. And deeper budget cuts certainly lie in Europe's future -- and eventually, the United States', too. We've had only a taste of these events thus far; Europe has seen most of them.
Demonstrations against the official response to the eurozone debt crisis -- including dramatic public-sector layoffs, retirement age increases and emergency property taxes tied to electric bills, among other things -- have helped topple the governments of Portugal and Ireland, brought new leadership into power in Spain and resulted in the installation of unelected technocrats in Greece and Italy.
Why? Because history hinges on protests like these -- protests spurred by economic weakness made worse by budget austerity, higher taxes and lost benefits.


Bread riots, combined with corruption, massive government debt and increased taxation, resulted in the French Revolution and the loss of King Louis XVI's head. American patriots fought for independence after the imposition of harsh new taxes on things like tea. And Adolf Hitler's rise to power was birthed by the turmoil and hardship created by the Great Depression, the gold standard's tight money and Germany's insistence on austerity to pay its World War I debts.
We haven't seen chaos just yet. But based on this economic view, and given the contents of last week's big eurozone agreement, Europe could be close to serious trouble. And we're headed that way.

The road to chaos

First, some context. I've written frequently about the eurozone problems and their structural underpinnings over the past few weeks. Last week's agreement by European Union leaders did nothing to change the situation, with its one-sided emphasis on stricter enforcement of budget austerity.

The outcome, an intergovernmental treaty, will create yet another layer of supranational governance in Europe to accompany the European Union, the European Economic and Monetary Union, the European Parliament, the European Council and the European Commission.
Hopes and dreams of a massive increase in the eurozone's bailout power and/or massive intervention by the European Central Bank crashed into the rocks of reality. Germany insisted that the maximum bailout power be capped at 500 billion euro, roughly $659 billion. And the ECB continues to resist all calls for it to engage in belligerent monetary financing of the likes of Italy and Spain -- pointing out that its existing bond purchase program is "limited in scope and longevity" and that there is "no possibility of greatly expanding ECB bond purchases" according to an official.
Essentially, it all boils down to this: Germany and France are asking Greece and Portugal to embark on an impossible task of "internal devaluation" to boost export competitiveness at a time of fiscal vulnerability. Greeks would take a hit to protect French and German bankers.
It won't work. You can't ask an entire country to take pay cuts and work longer hours for less at the same time you offer fewer social benefits and increase taxes. Not only will the economy not grow, but your deficits will get even worse. And your banks will get hit with more deposit outflows and loan losses.
This last point is key.

The damage done by austerity

A few months back, I wrote extensively about fiscal austerity and the damage it causes a weak economy, and showed how this related to the fierce debates in Washington between Obama and the Republicans. I warned of focusing too intently on fiscal woes and the debt burden while ignoring the need to support the economy over the short term. This was the fool's errand behind the 1937 double-dip recession that made the Great Depression so terrible.



Instead, I recommended a focus on short-term growth (to fix the cyclical portion of the deficit) and a commitment to tackling the real, structural drivers of the medium-term budget problems, namely, health care spending. (For more, read "Why Obama needs to spend more" as well as the work of Francois Velde, senior economist at the Federal Reserve Bank of Chicago.)
The current predicament combines all these things into one fantasy, a delusion shared by elements of the Tea Party as well as the pushers of austerity in France and Germany: that you can cut your way to prosperity. You can't. New research by the International Monetary Fund, looking at efforts to close budget deficits in 17 wealthy countries since 1978, found a clear link between slower economic growth and higher taxes and lower spending.
This shouldn't be surprising, given the anecdotal evidence around us. The British economy is stagnating as its coalition government pushes through even more tightening measures. And the Greek government is experiencing firsthand the downward dynamic of recessionary austerity: Budget deficits were higher than expected for the first 11 months of 2011 as the economy weakened more than forecast, resulting in lower tax collections and higher spending on social programs.

Austerity just won't last

Of course, you can ignore some of my warnings about austerity for a simple reason: It won't last.

Recessionary austerity is a political nonstarter because it can lead only to more rioting, more protests and more government overthrows. In other words, people get so mad at austerity that it probably won't last long, even in a country as troubled as Greece.
I give it an additional six months before Athens gives it up, tells Berlin to back off, drops the euro and follows the example of Iceland by restoring its national currency (for Greece, the drachma) and devaluing it -- just as country after country in the 1930s abandoned the monetary straitjacket that was the gold standard.
Those that left first, including the United Kingdom and Sweden in the fall of 1931, suffered the least.
The way things are going, deeper budget cuts are coming, with predictable results. On current forecasts from the Organisation for Economic Co-operation and Development, Greece is on track to tighten its fiscal balance by an average of nearly 2% between now and 2013, Ireland by nearly 8%, Portugal by 2.3% and Spain by 2.1%.
According to the research by Ponticelli and Voth, budget cuts of 2% or more of gross domestic product increase the risk of chaos events by nearly two-thirds. A 3% cut doubles the risk. These countries are in the danger zone.
The U.S. economy faces something similar. According to Congressional Budget Office estimates, the U.S. budget deficit will tighten by more than 2% of GDP next year -- increasing the risk of unrest as the 2012 election approaches. Things get critical in 2013 if nothing is done as an automatic $1.2 trillion in budget cuts (triggered by the failure of the congressional supercommittee to trim the budget) combines with the possible expiration of the Bush tax cuts, the payroll tax cut and extended unemployment benefits. Together, this will create a harsh, European-style austerity program worth nearly 3% of GDP.
I'll say it again: You can't cut your way to prosperity.

As the euro falls

So, what now?
UBS economist Stephane Deo, who has spent a lot of time over the past few months exploring the fallout from a eurozone collapse, notes that unless German taxpayers acquiesce to a transfer of wealth to the Greeks, Portuguese, Italians, Spanish and Irish -- just as federal money here at home is reallocated from strong states to weaker ones -- the eurozone as it stands now is doomed.


And even if a country like Greece leaves, it will have a long, hard road to recovery. In a recent research report to clients, Deo wrote that "weaker countries exiting a monetary union have tended to move to more authoritarian forms of government, or on occasion moved towards civil war." Which sounds frighteningly like, well, chaos.
Next week, tune in for thoughts on how investors can navigate an increasingly chaotic environment in 2012. Here's a hint: Things are looking a lot like the 1960s and 1970s, according to Morgan Stanley researchers. Stay tuned.