Lessons for Europe From Reagan's Austerity Measures

Austerity is - to put it bluntly - not going very well for a number of euro zone countriesforced to impose measures on their economies and voters.


"Since the start of the Greek crisis, most European countries have announced austerity measures to cut budget deficits to sustainable levels," Patrick Legland, the head of global equities at Societe Generale in Paris, wrote in a note to clients.

"However, in just two years, peripheral countrieshave launched as many as four austerity plans, with limited results so far," Legland added.

"On one hand, the public in peripheral countries are against new austerity measures as unemployment has surged, and, on the other, Germany is not ready to pay for everyone, particularly as the country has managed to keep unit labor costs under control since 2000," he said.

In a bid to find clues on how to trade the austerity measures now in place across much of Europe, Legland and his team at Societe Generale have been looking at the impact of Ronald Reagan's $41 billion worth of spending cuts in 1981 and it makes good reading for the stock market bulls.

"Equity markets are very resilient when austerity plans succeed," said Legland.

Now it remains to be seen if the governments of Greece and Irelandwill be lucky enough to succeed, but if things follow the same path as America in the early 80s you need to get out of long-term bonds and steer clear of the euro.

"Most often, currencies continued to weaken long after the launch of austerity plans. Therefore, euro strength is probably the reason why such plans in peripheral countries have not been successful thus far," Legland wrote.

The big risk to this positive view of austerity is inflation, according to Legland, who sees a worst-case scenario of rising inflation and recession.

"If we look at the link between inflation and GDP growth, we can observe that, during the last four US recessions, inflation picked up in three cases out of four."

In 1974, 1980 and 1990 an oil price spike led to inflation and then to recession. During the 2009 recession, inflation was not an issue. Now in 2011, signs of inflationary pressures are starting to appear, Legland said.