In the global economy, the past few months have been as bizarre as anything that could be imagined. And nowhere is this more evident at the moment than in Europe, where the crazy and unsynchronized tango between financial markets and governments now threatens the lives of ordinary citizens.

Consider the fear that is now supposedly spooking the markets, that of the possibility of sovereign default. At the frontline is Greece, the country that is being asked to impose an unbelievably severe austerity package that is bound to cause employment and incomes to spiral downwards, in return for a supposed ''improvement'' in state finance, which are nonetheless projected to be in parlous condition for years to come.

Just behind Greece come the next line of countries under attack, currently Spain and Portugal, and quite soon possibly the UK. Other governments that have been implementing draconian budget cuts already, like Ireland, Estonia and Latvia, still find it hard (and getting harder) to borrow money for new public debt.

Now, even countries that do not seem to be under pressure from financial markets (like France) and those that cannot possibly be under pressure because they have large current account surpluses (like Germany) are also announcing budget cuts and moves to fiscal austerity.

The funny thing is that, the more the governments announce budget cuts and other measures to squeeze out savings in the economy, the worse the hit that their bond markets seem to take. Interest rate spreads have been rising and signs of investor panic in sovereign debt markets spread just as governments try to placate markets by bowing to their pressures to cut government deficits. So, instead of being rewarded for good behaviour by the financial markets, they are being further punished.

What exactly is going on? It is really a case of the stupidity of markets being magnified by the apparently even greater stupidity of economic policy makers, who seem to be undertaking knee-jerk responses to changes in market sentiment, rather than engaging in strategies based on an appreciation of actual macroeconomic processes. As a result, their actions serve to generate precisely the opposite tendency from what was desired, thereby causing further financial panic.

Consider the current situation. The global economy is recovering from a major recession but the recovery is fragile, uneven and easily reversible. It is fairly obvious–and indeed was universally recognized in the midst of the financial crisis in 2008–that when private economic agents are caught in a liquidity trap or in a deflationary spiral, governments must increase their own spending and ease access to credit to keep the economy going. If they also cut spending and tighten monetary policy, they will worsen the downswing and possibly even cause a deep depression. In other words, macroeconomic policy should be countercyclical, not procyclical.

The only way this can be avoided is if the economy concerned tries to rely on global markets and increase its net exports, or if the attempt at stabilization somehow makes the economy appear very attractive to foreign investors who rush in to invest (which is typically very unlikely in a stagnant or declining market). The dependence upon foreign markets is why the IMF typically has advised this brutal combination of fiscal and monetary tightening to countries in deficit, effectively bringing on even sharper slumps in many of the countries that have taken their medicine.

But obviously, this is not something that all countries together can hope to do. So if all countries expect that external markets will save them, then all of them will sink together.

But that is precisely what all the economies in Europe are collectively expecting. This has another predictable result, which is that the attempt to reduce the fiscal deficit can become self-contradictory. Governments cut their spending and impose austerity measures. This then reduces incomes and employment immediately, and over time through the negative multiplier effects. As a result, government tax revenues come down. This can even lead to a worse fiscal deficit than before, as many countries have found in the past. In fact, it is well known that since tax revenues go down in a crisis or a recession, the fiscal deficit is bound to increase. Policies that aggravate the slump will only make it worse.

Now consider how this plays out in interaction with private financial markets. When private investors apparently decide that a country’s level of government debt is ''too high'' or that it has current account or fiscal imbalances that are ''too large'', the spread on interest on that government’s debt rises. Bond yields rise as bond prices fall. The country finds new borrowing more difficult and/or more expensive. The government then decides that it has to cut back on spending in order to reduce the deficit. The markets (or at least the financial media) applaud this decision. But then the cutbacks cause more economic pain in terms of reduced incomes and employment, which makes the growth prospects worse. So financial markets respond by further increasing the spreads on government debt! And so on. In fact, the prescription for austerity in these countries is bizarre because it undermines the foundations for economic growth without which they will never be able to repay existing debts.

This ridiculous drama can go on for a while, and the only thing that can stop it is decisive government action. But such is the control of the financial markets that they seem to have come to completely dominate public policy discussion, at least in Europe where these basic economic processes seem to have been forgotten. We have got to the point where even the US government is concerned at how this completely slavish and illogical response will threaten global economic recovery.

What is even more amazing is that surplus countries in Europe like Germany are also opting for fiscal austerity measures, even though these will definitely rebound adversely on growth in the entire region. As long as this peculiar combination of mercantilist expectation of exports saving all economies and emphasis on fiscal austerity in the midst of the downswing persists, it is hard to see how the world economy can really recover.

* This article has been published in Deccan Chronicle/Asian Age

June 04 , 2010.