When the housing bubble burst in 2006, U.S. policymakers looked to Japan for clues about what to do —and not do — in response. Their attention is shifting to Europe as the U.S. gets set to follow that region with an attack on its budget deficit.
Among the lessons being drawn: Don't put off budget action until the financial markets demand it; big, immediate cuts aren't always the best way to reduce deficits; and central bankers should be ready to try to offset the economic impact of fiscal contraction.
“The lesson of Europe is, don't wait until you're in a crisis to act. Do it now,” said Alice Rivlin, the founding director of the Congressional Budget Office. “The other lesson is that austerity is not a good prescription for weak economies.”
The stock market would benefit if the U.S. avoids the so-called fiscal cliff and reaches a deal to put the deficit on a decreasing path, said Jack Ablin, who helps oversee about $65 billion in assets as chief investment officer at BMO Private Bank.
“A credible plan would build confidence among investors,” he said.
Stock prices slumped in the days following the election, partly on concern that Congress will allow about $607 billion in automatic spending cuts and tax increases to go ahead next year.
“This would be self-inflicted, disorderly contraction that would unambiguously push our country into recession,” said Mohamed El-Erian, chief executive of Pacific Investment Management Co. LLC, which oversees more than $1.9 trillion in assets.
The center of fiscal restraint is rotating toward the U.S. from Europe, analysts at Barclays PLC said in an Oct. 11 report.
Belt-tightening is “a big theme globally, and there's going to be more focus on the U.S., which, in terms of fiscal consolidation, has done very little,” said Laurent Fransolet, head of European interest rate strategy at Barclays.
The U.S. has run deficits for 11 straight years, with a shortfall of more than $1 trillion in each of the last four years.
That has pushed publicly held debt as a percentage of gross domestic product to 67%, from 36% in 2007, according to data from the Office of Management and Budget.
The deficit for the fiscal year ended Sept. 30 was equivalent to 7% of the economy.
Some eurozone members have been forced into a swifter reckoning by investors' pushing up yields on their bonds -— a problem the U.S. has not faced so far.
The European Commission predicts that the Greek economy will shrink for a sixth straight year in 2013, contracting 4.2% after this year's 6% slide. Unemployment there is over 25%.
Portugal will lose 1% and Ireland will eke out growth of just 1.1%, according to the commission.
The experience of Europe's peripheral countries shows that U.S. policymakers should tackle swelling debt before investors compel them to do so, said Mark Zandi, chief economist at Moody's Analytics Inc.
“You don't want to address these problems in the middle of a fiscal crisis, because the costs will be enormous,” he said.
Britain, on the other hand, was not propelled into action by rising bond yields when the government of Prime Minister David Cameron began its deficit-busting drive in 2010.
The U.K. followed the same blueprint as its eurozone brethren, though, front-loading tax and spending cuts in the most severe fiscal tightening since that in the aftermath of World War II.
The result of the moves: a double-dip recession from which the British economy is just now recovering. The commission predicts that GDP will grow 0.9% in 2013 after shrinking 0.3% this year.
“The Brits learned the hard way that you can do a lot of damage if you don't phase in fiscal consolidation, especially when the economy is weak,” said Nariman Behravesh, chief economist at IHS Inc.
However, Britain managed to emerge from its recession sooner than some of its counterparts because the Bank of England has used unorthodox monetary measures to pump up the economy, Mr. Behravesh said.
In trying to cut debt as a share of the economy, policymakers also must focus on promoting growth, Mr. El-Erian said.
Failure to do so in Europe has often meant that austerity ended up hurting the economy so much that it worked against debt reduction.
For example, the commission forecasts that Greek debt will rise to 188.9% of GDP in 2014, from 176.7% this year. Under the country's second bailout agreement, debt was seen peaking at 167% of GDP in 2013.