Deficit hawks should think twice, and do something about health care cost, which is by far the most serious threat to the sustainability of the financial position of the US public sector…
How to walk the fiscal tightrope that lies before us
By Martin Wolf in the Financial Times
Niall Ferguson is not given to understatement. So I was not surprised
by the claim last
week that the US will face a Greek crisis. I promptly dismissed
this as hysteria. Like many other high-income countries, the US is
indeed walking a fiscal tightrope. But the dangers are excessive
looseness in the long run and excessive tightness in the short run. It
is a dilemma of which Prof Ferguson seems unaware.
Ferguson stated that, according to the White House projections, gross
federal debt will exceed 100 per cent of gross domestic product by 2012;
that the US is forecast never to run a balanced budget again; that
monetary policy, not deficits, saved the economy; that higher interest
rates are on the way; and, not least, that high fiscal debt is damaging.
DeLong of the University of California, Berkeley,
that parts of this argument are wrong or misleading: White House projections
are for federal debt held by the public to be 71 per cent of GDP in
2012 and not to exceed 77 per cent by 2020; monetary policy would not
have delivered even the limited recovery we have had on its own; and
higher interest rates may indeed be on the way, but there is nothing in
current yield curves to suggest it. Moreover, there is no reason to
balance budgets in a country whose nominal GDP grows at up to 5 per cent
a year in normal times.
Prof Ferguson is trying to frighten US
policymakers out of sustaining or, better still, increasing fiscal
stimulus, even though the true issue is longer-term sustainability. He
also accuses opponents of believing in a “Keynesian free lunch”. Not so.
The argument is, rather, that the benefits of the higher output today
exceed the costs of debt service tomorrow.
Prof Ferguson believes
instead in a conservative free lunch. This is the view that fiscal
tightening today would have little effect on activity. Normally, when
monetary policy has room for manoeuvre and the private sector’s
borrowing is unconstrained, that is right. But, as Olivier Blanchard,
chief economist of the International Monetary Fund, and colleagues note
in a recent report: “To the extent that monetary policy, including
credit and quantitative easing, had largely reached its limits,
policymakers had little choice but to rely on fiscal policy.”
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The high-income countries
that have experienced the biggest jumps in deficits and debts have,
inevitably, been Ireland, Spain, the UK and US, as Stephen Cecchetti and
colleagues at the Bank for International Settlements pointed out in
Future of Public Debt”, a paper presented last week at a conference
celebrating the 75th birthday of the Reserve Bank of India. These are
the countries that had the biggest credit booms and asset bubbles. It is
there, as a result, that private-sector spending has been most
constrained by the pressure to deleverage.
Jumps in fiscal
deficits are the mirror image of retrenchment by battered private
sectors. In the US, the financial balance of the private sector (the gap
between income and expenditure) shifted from minus 2.1 per cent of GDP
in the fourth quarter of 2007 to plus 6.7 per cent in the third quarter
of 2009, a swing of 8.8 per cent of GDP (see chart). This massive swing
occurred despite the Federal
Reserve’s efforts to sustain lending and spending. Similar shifts
occurred in other crisis-hit countries.
If these governments had
decided to balance their budgets, as many conservatives demand, two
possible outcomes can be envisaged: the plausible one is that we would
now be in the Great Depression redux; the fanciful one is that, despite
huge increases in taxation or vast cuts in spending, the private sector
would have borrowed and spent as if no crisis at all had happened. In
other words, a massive fiscal tightening would actually expand the economy. This is to
believe in magic.
huge increases in fiscal deficits were appropriate to the
circumstances. The only way to have avoided them would have been to
prevent prior expansions of private credit and debt. But Prof Ferguson
is right: everybody knows that such deficits cannot continue
indefinitely. As Carmen Reinhart and Kenneth Rogoff point out in a
once ratios of public debt to GDP exceed 90 per cent, median growth
rates fall by 1 per cent a year. That would be costly. Moreover, there
is a risk that, at some point, confidence would be lost and interest
rates would soar, with dire impact on debt dynamics.
difficulty, however, is that, as the McKinsey Global Institute has also
noted in a recent report:
“Historic deleveraging episodes have been painful, on average lasting
six to seven years and reducing the ratio of debt to GDP by 25 per
cent”. The only ways to accelerate this would be via mass bankruptcy or
inflation. If these are ruled out, what might support demand, while
deleveraging continued? If fiscal policy is also ruled out, the only
option would be foreign demand. But who is likely to offset contracting
demand in the US and other hard-hit economies? Nobody, alas, is the
Yet, as the BIS paper also noted, long-run fiscal
prospects, largely driven by ageing, are dire. Projecting forward from
the dreadful starting points, the BIS authors argue that ratios of
public debt to GDP could reach 250 per cent of GDP in Italy by 2050, 300
per cent in Germany, 400 per cent in France, 450 per cent in the US,
500 per cent in the UK and 600 per cent in Japan. If the sovereign debts
of high-income countries are not to be reduced to junk, these countries
do indeed need credible plans for retrenchment. On this there is no
disagreement. The best approach would be sharp reductions in long-term
growth of entitlement spending. Furthermore, as economies recover,
short-term fiscal action will be needed. Actions will have to include
spending cuts and increases in tax, to restore revenue lost forever in
Now we come to the big dilemma: what if private
deleveraging and fiscal deficits continue in the US and elsewhere for
years, as they did in Japan? Then triple A-rated countries, including
even the US, might lose all fiscal headroom. This has not yet happened
to Japan. It might well not happen to the US. But it could.
yes, high-income countries face huge fiscal challenges. And yes, the
crisis-hit countries start from grossly unsustainable fiscal positions.
But the US is not Greece.
Moreover, a massive fiscal tightening today would be a grave error.
There is a huge risk – in my view, a certainty – that this would tip
much of the world back into recession. The private sector must heal.
That, not fiscal retrenchment, is the priority.