Doubts about sovereign credit are forcing reductions in budget deficits at a time that the banks and the economy may not be strong enough to permit the pursuit of fiscal rectitude-George Soros

In English, what Mr. Soros is saying is that (European) austerity programs are coming at the exact worst time, because governments which implement them are likely to double-dip into recessions.

He also said the current economic situation is “eerily” similar to what happened during the Great Depression of the 1930’s. Then, as now, governments came under pressure to reign in deficit spending before their economies had fully recovered.

By 1936, much of the economy in the U.S. had regained the levels of the late 1920s, except for unemployment, which remained high at 11%. But pressure from conservative, deficit hawk politicians grew and in June 1937, the Roosevelt administration cut spending and increased taxes in an attempt to balance the budget.  As a result, economy again went into a recession through most of 1938, with unemployment increasing from 5 million to more than 12 million.

Now, there’s no indication as of yet that the Obama administration intends to cut the deficit, but the conservative political winds are growing stronger and if a wave of tea-partiers get elected in the mid-term elections, the President’s thinking on this could change even though now would be the absolute worst time to do this because the economy has not returned to pre-recession levels. For example, in real (inflation adjusted) terms, Q1 2010 GDP was 1.24% below the last high from Q2 2008 while the real gross added value of non-farm businesses remained 2.4% below where it was in Q4 2007.

However, a potential reduction in deficit spending is not the only concern which no doubt will begin to weigh heavily on equity markets before too long.

As Arthur Laffer pointed out in an opinion piece in the Wall Street Journal last week, tax hikes will be taking effect as of January 1, 2011 which he believes will lead to “a severe double dip recession.” He also made the point that income and demand is being shifted from 2011 into 2010, a “major reason that the economy in 2010 has appeared as strong as it has.”

We could be starting to see the effects of this happening already. Last Friday’s report on May’s Retail Sales was surprisingly weak, especially if you look at sales excluding auto, gas stations and hardware stores, which is what the government uses in calculating GDP. This core measure rose just 0.1% in nominal terms after a 0.2% gain the previous month (CPI for May will be released on June 17, so we’ll be able to calculate the real number). As a result, expect to see economists revise down their Q2 GDP forecasts as personal consumption figures to make a smaller contribution to the economy than previously estimated.

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