Four years after the onset of the recession, the U.S. is recovering weakly, Europe isn’t recovering at all, and prospects in the rest of the world are far from thrilling. It’s an outlook that makes curbing public debt hazardous, yet governments everywhere are deciding that the job can’t wait.
They’re half-right. To think fiscal control can be postponed indefinitely is foolish. Believable plans to curb public borrowing would calm financial markets and reduce the risk of spikes in long-term interest rates. But the policy has to be patient and methodical, because doing too much too soon is even riskier than doing nothing. The combination of weak demand and harsh fiscal restraint -- not just in one country or region, but globally -- is a death trap, especially if overzealous monetary policy is part of the mix, as in Europe.
If you need persuading, read the case studies in Chapter 3 of the International Monetary Fund’s new World Economic Outlook (published to coincide with the global finance ministers’ meeting that starts next week).
The debate about the right pace of fiscal restraint is polarized. At one extreme is the view that severe austerity has to start yesterday. Some even say that big cuts in public spending would give confidence such a boost that private spending would rise for a net increase in demand -- “expansionary austerity” as it’s called. At the other extreme is the idea that public debt will melt away of its own accord once growth picks up. Fiscal austerity isn’t just unnecessary, in this view, it’s self-defeating, because it slows growth.
As you might expect, the truth is in between. Fiscal restraint, other things equal, subtracts demand and slows recovery. Expansionary austerity doesn’t work. On the other hand, countries with high and rising public debt (more than 100 percent of output, say) seem to suffer a growth penalty. There’s no clear boundary between good and bad debt ratios, says the IMF, and the connections between debt and growth are complicated, but high levels of debt can’t be left to take care of themselves.
So the question for highly indebted countries is not whether to control public debt but how to do it without killing the recovery. The IMF’s case studies shed some light on this -- though the findings aren’t hugely encouraging.
One benchmark is the U.K.’s experience after 1918. By the end of the First World War, the country’s debt had risen to 140 percent of output. The government resolved to pay off the debt and bring prices, which had doubled during the war, back to where they’d been in 1914. The idea was that the debts would be honored in full, rather than repaid in a devalued currency.
The results were catastrophic. Growth was so badly hammered that the debt ratio, after dipping in the mid-1920s, kept rising despite budget surpluses all through the decade. By 1933, it was 190 percent of GDP. Other European countries were devaluing their currencies, so British competitiveness suffered and weak exports made the slump even worse.
Admittedly, it’s an extreme case. Still, the parallel with Europe today is hard to miss. Spain and other distressed debtors are undergoing severe fiscal retrenchment. Monetary policy isn’t aiming for outright deflation, but a new central bank that wants to establish its anti-inflation credentials is being less accommodating than it could be. There’s no intra-European exchange rate to devalue, so countries like Spain can’t boost their competitiveness that way. It’s a formula for endless recession.
The case studies suggest two better alternatives -- though the first is a little too seductive. That’s the U.S. after 1945. The war increased U.S. public debt 10-fold, to 120 percent of output. The ratio came down thanks to fairly tight fiscal policy, very loose monetary policy, inflation (which reduced the debt ratio by expanding the nominal value of output), and administrative measures to prevent the rise in nominal interest rates that inflation would otherwise have caused. The economy grew at a good clip, and the debt came down.
It was a good mixture, but difficult to replicate today. Those administrative measures -- “financial repression” is the term of art -- would be hard to impose on today’s vastly more complex and sophisticated financial markets. Without them, inflation would push nominal interest rates higher, blunting the beneficial effect on the debt ratio. Even if it could be done, the Federal Reserve would rightly hesitate to rely so much on inflation, because it might destroy the reputation the central bank built at such cost in the 1980s.
The third approach is suggested by the case studies of Belgium (1992-2002), Canada (1995-2005) and Italy (1997-2007). In all three countries, fiscal restraint was combined with relative monetary ease. Where austerity took the form of long-term structural reforms, rather than temporary expedients, it worked better. Also, in Belgium and Canada, strong demand from abroad helped alongside monetary policy to support growth as public borrowing was scaled back.
That last point is the main ground for pessimism about the global economy today. Too many countries are trying to pursue the same strategy at once. As the IMF says, “The implications for today are sobering -- widespread fiscal consolidation efforts, deleveraging pressures from the private sector, adverse demographic trends, and the aftermath of the financial crisis are unlikely to provide the supportive external environment that played an important role in a number of previous episodes of debt reduction. Expectations about what can be achieved need to be set realistically.”
Fiscal shock and awe is suicidal in these circumstances. Governments need to make their fiscal retrenchment gradual. (Think of the “fiscal cliff” in the U.S. Do the opposite of that.) Central banks meanwhile -- Europe’s especially -- must keep monetary policy loose. (Think of the Federal Reserve in the U.S. Do the same thing, only more so.) The lack of any plausible “external support” for struggling economies tilts the policy-balance further in the direction of taking a measured risk with inflation -- that is, if any such risk were apparent right now, which it isn’t.
The situation is serious, but it’s never too late for ham-fisted austerity plus exaggerated monetary rectitude to make things hopeless.
(Clive Crook is a Bloomberg View columnist. The opinions expressed are her own.)
Today’s highlights: the editors on how to avert the fiscal cliff and on New York’s lawsuit against JPMorgan Chase & Co.; Margaret Carlson on the election as a referendum on Mitt Romney; Michael Kinsley on which gaffes will matter at the debates; Peter Orszag on the widening U.S. longevity gap; Meghan L. O’Sullivan on the silver lining in the Muslim anti-American riots; Thomas de Waal on Georgia’s democratic counterrevolution.
To contact the writer of this article: Clive Crook at firstname.lastname@example.org.
To contact the editor responsible for this article: James Gibney at email@example.com.