Financial markets saw a mild risk on rally at the close of Friday’s North American trade, a rally that is continuing to extend in today’s Asian and early European dealing. The rally has been sparked by investor optimism over the issue of resolving the US Fiscal Cliff budget problems with US lawmakers making conciliatory remarks on Friday. However the Fiscal Cliff issue may be a case of careful of what you wish for, as the resolution of the problem may actually pose a greater risk to the US economy than keeping the current policy as status quo.

Whatever compromise on Fiscal Cliff is made, the end will be austerity at a time when the US economy can least afford it. The policy solutions to the Fiscal Cliff all revolve around the idea of lowering government spending and increasing a variety of taxes. In short, Fiscal Cliff has simply become a code word for austerity politics.

The policies of austerity politics have been a miserable failure in the EZ as that region slowly sinks into a recession and are very likely to cause a massive slowdown in the US economy if the same policy path is followed across the Atlantic. Perhaps the starkest demonstration of the divergence between US and EZ can be seen in the employment data of the two economies. Since the peak of credit crisis of 2008 US unemployment has improved in a slow and steady fashion from near 10% level to now below 8%. Unemployment in the EZ however has continued to rise hitting its all time peaks last month at above 11.5%. During that time US employed a moderately stimulatory fiscal policy and a highly accommodative monetary one, while EZ officials forced many of their member nations to slash budgets in response to the sovereign debt crisis in the region.

The policy message of the past several years is startlingly clear. Austerity politics depresses aggregate demand and only exacerbates economic hardship. US may be in the process of repeating the mistakes on 1938, when a modest recovery convinced US policymakers to tighten fiscal spending by “balancing the budget” and sent the country into the second wave of the Great Depression.

Today’s economic picture looks far less dire but no less dangerous. If US policymakers proceed to curb aggregate demand by a combination of tax hikes and spending cuts, the global economy may slow more than the market expects. With EZ economy in contraction and China’s economy in a slowdown US was viewed as the only engine of growth for global demand, but if Fiscal Cliff problem is resolved with some sort of a legislative compromise, the decline in US demand could trigger a domino effect throughout the world causing further contraction.

That’s why over the next several months the US employment data will an even more important barometer of economic health. If labor demand begins to slow it will signal that “austerity politics” are failing once again and the rally in risk FX will dissipate with realization.

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