The most important financial debate of our times.
If you have been following the financial press as of late, you’re probably well aware that there is a contentious debate between deficit reduction hawks and those who call for the more state spending to boost global demand. At the latest juncture of this debate, Toronto’s G20 summit, the international community sided with the deficit hawks and committed to halve deficits by 2013. One would imagine this hysteria over public debt is a response to market pressure. Not so, say the bond markets. The latest calls for debt reduction, far from a reasoned response to economic reality, are products of an ideological opposition to a strong state sector:
Instead of bond market fears, the US has an intense political debate about deficits and whether to spend more on fiscal stimulus. Steny Hoyer, the Democratic leader in the House of Representatives, has talked of “spending fatigue”. His Republican opponents have set up “YouCut” – a weekly public vote on which spending to cut, American Idol-style.
That’s right, there is no evidence that the major economies, particularly the United States, will face any difficulties financing increased stimulus. ‘Invisible bond vigilantes’ seem unfazed by sovereign debt, as interests rates remain low. By almost every indicator–unemployment, consumer confidence, housing prices–the United States economy is lagging. Now seems the perfect time for stimulus, it’s easy to borrow and the economy is in need. As Martin Wolf points out, in order to prevent short-term economic obstacles from becoming long-term structural deficits, the United States can quite easily expand the money supply and then contract it during the subsequent boom–a course of action recommended by none other than Milton Friedman (far from defender of a profligate state sector). But alas, politics always trumps reality. Despite the plight of the unemployed and the strong evidence that fiscal tightening during down years is contractionary, the government is cutting jobless benefits.
The cuts are not simply fuelled by Republican hypocrisy, indeed this climate of fiscal austerity is global:
The rich world looks set for a collective fiscal adjustment worth around 1% of its combined GDP next year, the biggest synchronised budget contraction in at least four decades.
The climate in the United States pales in comparison to the austerity hysteria that is sweeping the eurozone. Finance ministers warn of the sovereign debt crisis spreading from Greece to Italy to Spain to Ireland, and so on and so forth.
Proponents of fiscal stimulus argue that opponents are missing the larger picture: the real worry is not so much fiscal deficits, but an inability to grow out of them. That is to say, if we can’t nurture this very precarious recovery today, we risk long term structural deficits that could destabilize the world economy, cause a deflationary trap, collapse the eurozone, and ultimately send us into a third depression.
Paul Krugman, the most vocal proponent of increased stimulus, fits somewhere on the fringe of acceptable mainstream opinion. Krugman has been labelled “crude” and “extreme” for his increasingly subversive views (see the column in which he equates deficit hawks with Iraq War hawks, dismisses Republicans as hypocritical defenders of the wealthy, and implies German hawks are afflicted by cognitive dissonance). However, these worries will be hard to continue to dismiss. Bank of Canada Governor Mark Carney has warned that slashing spending, coupled with deficient demand (thanks in large part to the frugality of developing nations) could slump global growth to less than 1% of GDP.
The big question, then, is whether deficits can be financed. My answer is: yes. Remember that so long as the private sector runs financial surpluses it must buy claims on the public sector, unless the developed world as a whole is about to move into huge external surpluses.
Without any evidence of real bond market pressure, this deficit hysteria has been interpreted by some as a plundering of public finances for private gain. Can we simply deride this view as unhinged radicalism when we see that the UK emergency budget disproportionately affects the poor by cutting public services and eviscerating welfare payments?
Let’s be clear, there are long-term budget problems that need to be rectified. But you aren’t a hard-headed realist for attacking the poor, you are simply avoiding those real problems. Raghuram Rajan (one of the few to predict the recent financial crisis) identifies three very real structural problems:
- A stagnation of wages has worsened inequality (largely due to the financialization of the economy over the past thirty years). The response, rather than structural reform, has been increased borrowing (“credit as a palliative”) to lower income segments of the population.
- A lack of a social safety net has put the government under intense pressure during times of economic hardship. The strategy employed to alleviate those hurt most by the lack of a social safety net (lowering interest rates and increasing spending to boost demand) have incentivized the financial sector to making high-risk loans, further jeopardizing the stability of the economy at large. Moreover, the US budget problem is really a health care problem. The United states has exorbitant health care spending achieving nothing but dismal results and structural deficits. (Notice social security is really a non-issue budget-wise. The Economist shows it’s true ideological colours by specifically singling out social security and failing to mention health care as a long term budget issue).
- A global imbalance between production and consumption. Export-oriented economies (e.g. nation states coddling their manufacturing sectors) have lead to a dependence on other nations for continued consumption. This has weakened he domestic sector and demonstrated itself as an unsustainable strategy for long-term growth.
But confronting these issues would require seriously thinking about the way we have structured our economies, something our finance ministers are clearly not capable of. So while this debate between spending and cutting rages on, let’s just pray China can pull us out of this!