Yet those who profess faith in the magic of the markets are most determined to
ignore the cry. The fiscal skies are falling, they insist.
HSBC forecasts that the economies of high-income countries will now grow by
1.3 per cent this year and 1.6 per cent in 2012. Bond markets are at least
as pessimistic: US 10-year Treasuries yielded 1.98 per cent on Monday, their
lowest for 60 years; German Bunds yielded 1.85 per cent; even the UK could
borrow at 2.5 per cent. These yields are falling fast towards Japanese
levels. Incredibly, yields on index-linked bonds were close to zero in the
US, 0.12 per cent in Germany and 0.27 per cent in the UK.
Are the markets mad? Yes, insist the wise folk: the biggest risk is not slump,
as markets fear, but default. Yet if markets get the prices of such
governments’ bonds so wrong, why should one ever take them seriously?
The massive fiscal deficits of today, particularly in countries where huge
financial crises occurred, are not the result of deliberate Keynesian
stimulus: even in the US, the ill-targeted and inadequate stimulus amounted
to less than 6 per cent of gross domestic product or, at most, a fifth of
the actual deficits over three years. The latter were largely the result of
the crisis: governments let fiscal deficits rise, as the private sector
savagely retrenched.
To have prevented this would have caused a catastrophe. As Richard Koo of
Nomura Research has argued, fiscal deficits help the private sector
deleverage. That is precisely what is happening in the US and UK. In the US,
the household sector moved into financial surplus after house prices started
to fall, while the business sector moved into surplus in the crisis.
Foreigners are persistent suppliers of capital. This has left the government
as borrower of last resort. The UK picture is not so different, except that
the business sector has been in persistent surplus.
So long as the private and foreign sectors run huge surpluses (despite the
ultra-low interest rates), some governments must find it easy to borrow. The
only question is: which governments? Investors seem to choose one safe haven
per currency area: the US federal government in the dollar area; the UK
government in the sterling area; and the German government in the eurozone.
Meanwhile, among the currency areas, adjustment occurs far more via the
exchange rates than through interest rates on safe-haven debts.
The larger the surpluses of the private sectors (and so the bigger the
offsetting fiscal deficits), the faster the former can pay down their debts.
Fiscal deficits are helpful, therefore, in a balance-sheet contraction, not
because they return the economy swiftly to health, but because they promote
the painfully slow healing.
One objection - laid out by Harvard’s Kenneth Rogoff in the Financial Times in
August - is that people will fear higher future taxes and save still more. I
am unpersuaded: household savings have fallen in Japan. But there is a good
answer: use cheap funds to raise future wealth and so improve the fiscal
position in the long run.
It is inconceivable that creditworthy governments would be unable to earn a
return well above their negligible costs of borrowing, by investing in
physical and human assets, on their own or together with the private sector.
Equally, it is inconceivable that government borrowings designed to
accelerate a reduction in the overhang of private debt, recapitalise banks
and forestall an immediate collapse in spending cannot earn a return far
above costs.
Another noteworthy objection - grounded in the seminal work of Prof Rogoff and
Carmen Reinhart of the Peterson Institute for International Economics in
Washington - is that growth slows sharply once public debt exceeds 90 per
cent of GDP. Yet this is a statistical relationship, not an iron law. In
1815, UK public debt was 260 per cent of GDP. What followed? The industrial
revolution.
What matters is how borrowing is used. In this case, moreover, we need to
consider the alternatives. If the fiscal deficit is to be sharply reduced,
the surpluses in the rest of the economy must also fall. The question is how
that is to be compatible with rapid deleveraging and expanded spending. In
my view, it cannot be. A more likely outcome, in present circumstances, is
mass default, shrinking profits, damaged banks and a renewed slump. That is
what would happen if today’s contained depression ceased to be contained.
The danger is particularly imminent in the eurozone. Much can be argued in
response to the FT column by Wolfgang Schäuble, Germany’s finance minister.
But two points stand out. First, it is impossible for both governments and
private sectors of deficit countries to pay down - as opposed to default on
- their debt, without running external surpluses. What is Germany doing to
accommodate such an external shift? Next to nothing. Second, inside a
currency union, a big country with a structural current account surplus is
nigh on compelled to finance counterpart deficits. If its private sector
refuses to do so, the public sector must. Otherwise, its partners will
default and their economies collapse, so damaging the exporting economy. At
present the European Central Bank is offering much of the needed finance.
Does Mr Schäuble actually want it to stop?
Contrary to conventional wisdom, fiscal policy is not exhausted. This is what
Christine Lagarde, managing director of the International Monetary Fund,
argued at Jackson Holelast month. The need is to combine borrowing of cheap
funds now with credible curbs on spending in the longer term. The need is no
less for surplus countries with the ability to expand demand to do so.
It is becoming ever clearer that the developed world is making Japan’s mistake
of premature retrenchment during a balance-sheet depression, but on a more
dangerous - far more global - scale. Conventional wisdom is that fiscal
retrenchment will lead to resurgent investment and growth. An alternative
wisdom is that suffering is good. The former is foolish. The latter is
immoral.
Reconsidering fiscal policy is not all that is needed. Monetary policy still
has an important role. So, too, do supply-side reforms, particularly changes
in taxation that promote investment. So, not least, does global rebalancing.
Yet now, in a world of excess saving, the last thing we need is for
creditworthy governments to slash their borrowings. Markets are loudly
saying exactly this. So listen.
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