Let’s look at what has happened since the G20 concluded on Sunday. The G20 communique recommended that fiscal restraint be the order of the day: “There is also a risk that the failure to implement consolidation where necessary would undermine confidence and hamper growth. Reflecting this balance, advanced economies have committed to fiscal plans that will at least halve deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016.”

But the G20 seems to be only half-heartedly committed to fiscal restraint, since the communique also pointed out: “There is a risk that synchronized fiscal adjustment across several major economies could adversely impact the recovery…Fiscal consolidation plans will be credible, clearly communicated, differentiated to national circumstances, and focused on measures to foster economic growth.”

The Bank for International Settlements (BIS) was straightforward in its demand for fiscal and monetary restraint. In its annual report, released on Monday, the BIS emphatically stated that governments must slash budget deficits decisively and central banks should not wait too long to raise borrowing costs.

On the same day, Paul Krugman, writing in the New York Times, expressed his dismay at the G20. He would have been even more shocked and angered by the BIS annual report. Professor Krugman warned that global policy makers are making the same mistakes as their Depression-era predecessors by pulling back too early on stimulus measures, a move blamed for prolonging the ugliness of the 1930s.

While few economists agree with Krugman’s dire prediction, Carl Weinberg, chief economist with High Frequency Economics, also issued a similar warning: “You don’t push down when you’re already going down anyhow, so I think it’s a mistake…It’s a mistake for Britain to make cuts this year, it’s a mistake for the Europeans. Whereas I was expecting a flat economy for Europe and Britain, I’m now looking for declines.”

So who is right, for the stakes are extremely high?

When I taught macroeconomics, I presented various theories that ran the gamut from fiscal policy being very effective in stimulating demand to “stimulative” fiscal policy negatively impacting demand. The assumptions drove the conclusions, and the key assumption was the impact budgetary deficits might have on confidence. Is Krugman right, and is more stimulus needed to boost demand and more importantly confidence? Or is the BIS and G20 right that fiscal retrenchment and balanced budgets will boost confidence and demand? What policy is more likely to win the race to boost confidence?

Now let’s get back to reality.

Equity prices and interest rates plunged on Tuesday after signs of slowing economies form China to the U.S. spooked traders who were already uneasy about a global recovery. The Conference Board’s Consumer Confidence Index in the U.S. fell sharply in June on worries about the labor market. The Conference Board also corrected its leading economic index for China to an April gain of 0.3% from a previously reported rise of 1.7%, a sharp revision that undermined confidence in China’s ability to sustain strong growth and offset the negative impacts of fiscal restraint in the EU and elsewhere.

Peter Brockvar, an equity strategist at Miler Tabak in New York, noted: “The hint of moderation is what alarmed markets as it comes in the context of fragile U.S. and European economies at a time we look to Asia as the global economic savior.”

As noted, yesterday the bond market sided decisively with the deflationary camp as U.S. rates crashed through a pair of psychologically important milestones. The yields on 10-year U.S. Treasury notes dropped below 3%, and the rates on 30-year U.S. Government bonds fell below 4%. These are levels that have only been seen during the worst periods of the 2008-09 market panic.

David Rosenberg, chief economist at Gluskin Sheff and Associates in Toronto, pointed to the decline in rates and argued: “The bond market is telling a very important story here and it is one of a deflationary depression.”

An Associated Press report yesterday highlighted that forecasters think U.S. sales of cars and light trucks have slowed in June after months of improvement. “It’s another sign that people are beginning to doubt the economic recovery with unemployment still high.”

And the New York Times published a story yesterday as well about Ireland and its experience to date with fiscal restraint (or consolidation to use the language of the G20). According to the report: “Nearly two years ago, an economic collapse forced Ireland to cut public spending and raise taxes, the type of austerity measures that financial markets are now pressing on most advanced industrial nations. Rather than being rewarded for its actions, though, Ireland is being penalized. Its downturn has certainly been sharper than if the government had spent more to keep people working. Lacking stimulus money, the Irish economy shrank 7.1% last year and remains in recession. Joblessness in this country of 4.5 million is above 13%”.

Ireland’s Prime Minister, Brian Cowen, was quoted in this article as saying: “The facts are that there is no easy way to cut deficits. Those who claim there’s an easier way or a soft option – that’s not the real world.”

So who is right – the BIS and some of the G20, or Krugman? I’m betting on Krugman!

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.