Why saving the world economy should be affordable By Martin Wolf
Financial Times Published: March 17 2009 19:57
Can we afford this crisis? Will governments destroy their solvency, as they use their balance sheets to rescue over-indebted private sectors?
The debate, as it has so often been, is between the US and Germany. Thus, in a speech last week, Tim Geithner, US Treasury secretary, noted that, ?The IMF has called for countries to put in place fiscal stimulus of 2 per cent of aggregate GDP each year by 2009-10. This is a reasonable benchmark to guide each of our individual efforts. We think the G20 should ask the IMF to report on countries? stimulus efforts scaled against the relative shortfall in growth rates.? Needless to say, no such firm pledge was forthcoming, with Germany particularly resistant.
Nevertheless, a great deal of fiscal stimulus has occurred. This is what readers of recent research on the aftermath of financial crises by Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard would expect. These authors concluded from studying 13 big financial crises that the average rise in real public debt in the three years following a banking crisis was 86 per cent. In some of these cases, the increase was more than 150 per cent*.
So, is there good reason to expect huge increases in public sector indebtedness across the globe, not least in triple A rated sovereign borrowers ? The answer is: yes. If so, does this guarantee defaults of some kind? The answer is: no. In a recent paper, the staff of the International Monetary Fund suggest why these are the right answers**.
By 2012, suggests the IMF, the ratio of gross public debt to gross domestic product could be 117 per cent in Italy; 97 per cent in the US; 80 per cent in France; 79 per cent in Germany; and 75 per cent in the UK. In Japan, still scarred by the legacy of a huge bubble, the ratio could hit 224 per cent. Current forecasts are evidently much higher than those made before the crisis hit.
Yet the jumps in indebtedness are not particularly onerous, provided the willingness of governments to avoid default is not in question. Assume, for example, that the real interest rate these highly rated countries pay is 1 percentage point higher than the long-term growth rate of their economies. Then the requirement for stabilising a ratio of public debt to GDP at 100 per cent is a primary budget surplus (surplus before interest) of just 1 per cent of GDP.
Nevertheless, three counter-arguments can be advanced.
First, in some cases, primary fiscal deficits are very large. Among bigger advanced countries, this is particularly true for this year ? in the US, forecast at minus 9.9 per cent of GDP; Japan and the UK, both forecast at minus 5.6 per cent; and Spain, forecast at minus 4.9 per cent. The primary deficits of France, Germany and Italy are far smaller, at minus 3.6 per cent; minus 1.1 per cent; and plus 1.1 per cent, respectively. So stabilising debt requires large fiscal adjustment in some countries.
Second, the political willingness to curb deficits, by raising taxes or cutting spending, may come into question. This could become a self- fulfilling prophecy, with flight from debt raising interest rates, necessitating ever more costly (and so less plausible) fiscal tightening.
Third, the ultimate rise in indebtedness could be far bigger than the IMF forecasts. This would be consistent with experience. The primary explanation would be that the world economy is embarked on a prolonged balance-sheet deflation, comparable to Japan?s in the 1990s.
I would argue against these points.
First, markets are optimistic about the fiscal prospects: expected inflation remains well contained in the US and UK and interest rates on conventional 10-year US and UK government bonds are still below 3 per cent.
Second, the cost of meeting the added burden of ageing is far higher than any plausible cost of the crisis. On IMF forecasts, the present value of the fiscal costs of ageing in the US is 15 times the cost of the crisis.
Third, it makes no sense to avoid action that would greatly lower the real economic costs of the crisis now, to eliminate a hypothetical and avoidable fiscal crisis later on. This would be like committing suicide in order to stop worrying about death.
Nevertheless, it is wise to limit longer-term fiscal risks. The most important actions are to curb long-term age-related spending. But there is also a current agenda: rebalancing of world demand.
Surplus countries subcontract to their trading partners the job of spending oneself into bankruptcy, while lecturing the latter on their profligacy. Thus the reason the US, the UK and Spain have huge fiscal deficits is that they are offsetting the collapse of private spending at home and the export of demand abroad. This is unsustainable, in the long run.
The danger now is that the surplus countries expect recovery to come from enormous and sustained fiscal expansion in deficit countries. Some analysts argue that the US should have refused to take fiscal action at all, leaving it to surplus countries. Unfortunately, that would have meant a global depression. Nevertheless, without rebalancing there can be no healthy recovery. On this point, the US is right and Germany is wrong.