Martin Wolf has a very good comment in the Financial Times, “Why Obama’s plan is still inadequate and incomplete,” which readers might tempted to ignore, since the headline suggests the piece reaches a conventional conclusion: the Obama stimulus plan is too small.
That would be a mistake.
The Wolf article (as others have done) does indeed conform with the conventional view that an US stimulus program needs be bigger to get the economy at least somewhat back on track (we’ll put aside for now the question of whether this is the best way of going about things, or whether less stimulus and more microeconomic reform particularly cleaning up the banking system and improving regulations, might lead to a better trade off of short-term pain for longer term gain).
Wolf reaches two conclusions not widely presented in the US media:
The stimulus would need to be MUCH bigger to reach its goals. Many US commentators suggest that 50% to 100% bigger is closer to the mark.
The US is going to have to run deficits for a long time. A VERY long time.
Wolf’s back of the envelope calculation of the level of stimulus needed:
In last week’s column (“Choices made in 2009 will shape the globe’s destiny”, January 6) I argued that the debt-encumbered US private sector would now be forced to save …. The excess of income over expenditure in the private sector might be, say, 6 per cent of GDP for a lengthy period. If the structural current account deficit remained 4 per cent of GDP, the overall fiscal deficit would need to be 10 per cent of GDP. Moreover, this would be the structural – or full employment – deficit.
The Congressional Budget Office forecasts that US output will be 7 per cent below potential over the next two years, on unchanged policies. If so, the actual deficit should now be much larger than the structural one. It is easy to see, therefore, why the critics argue that the Obama plan for an additional fiscal stimulus of 5 per cent of GDP over two years is too small, even though the CBO forecasts a baseline deficit of 8.3 per cent of GDP this year. It is also easy to understand why many object strongly to tax cuts, since the more likely cuts are to be saved the larger the package must be – and, in addition, taxes will clearly have to rise in the longer term.
So if I have this right, “needed” stimulus is the 10% (full employment” deficit + 7%, or 17% in each of the next two years. What Obama is delivering is 5% over two years, or 2.5% a year, plus a baseline of 8.3%, for a total of 10.7%.
So to get where we need to get (if you buy the logic of this sort of exercise) is an additional 6.3% PER ANNUM deficit as a % of GDP. Remember, Obama’s plan is roughly 2.5% per year. 6.3/2.5= 2.5 times.
Read that again, If you believe the math, Obama’s program would need to be 2.5 times bigger to live up to its billing. And that is before you get into details like “tax cuts are likely to be less effective than other measures”.
But that isn’t what worries Wolf the most:
The bigger point, however, is not that the package needs to be larger, although it does. It is that escaping from huge and prolonged deficits will be very hard. As long as the private sector seeks to reduce its debt and the current account is in structural deficit, the US must run big fiscal deficits if it is to sustain full employment.
That leads to the third point Mr Obama’s advisers must make. This is that running huge fiscal deficits for years is indeed possible. But the US could get away with this only if default were out of the question.
At the end of the Napoleonic wars, the UK had a ratio of public debt to GDP of 270 per cent. This was brought down over a century: growth, the gold standard and the commitment to balanced budgets did the trick (see chart). The question is how much debt the US (or UK) can accumulate now. My guess is that the US could hope to run large deficits for years if these were used to finance the creation of high-quality assets. But the policy could not safely endure throughout a two-term presidency.
Yet, contrary to widespread belief in the US, a swift return to small fiscal deficits, high employment and rapid growth will not occur spontaneously. It is necessary to make structural changes in the US and world economies first. This is the last point Mr Obama’s advisers must make.
What then are these changes?
First, there must be a credible programme for what Americans call “deleveraging”. The US cannot afford years of painful debt reduction in the private sector – a process that has still barely begun. The alternative is forced writedowns of bad assets in the financial sector and either more fiscal recapitalisation or debt-for-equity swaps. It also means the mass bankruptcy of insolvent households and forced writedowns of mortgages.
All this would also lead to big one-off increases in public debt. But those increases would probably be much smaller than those generated by a decade of huge fiscal deficits. The aim is to have a slimmer and better-capitalised financial system and a healthier non-financial private-sector balance sheet, sooner rather than later. The troubled asset relief programme should be used for these purposes. It will need to be bigger.
Second and most important, the structural current account deficit has to diminish. The US private sector is no longer in a position to run huge financial deficits as an offset to the demand-draining external deficits. The public sector can do so only for a few years. In the long run, the world economy must be sustainably and healthily rebalanced. This is a huge challenge for international economic diplomacy. It is also an essential element of sound domestic policy.
This is sobering stuff. Comparing what might be in store to the US to the UK after the Napoleonic Wars is a polite way of saying that level of indebtedness is a non-starter (I’ve also noted other commentators suggest the US could run the sort of fiscal deficits we incurred during World War II). . The populace and the rest of the world is somewhat (stress somewhat) more kindly disposed toward borrowings incurred to assure national survival than to go on a national shopping spree.
And what medicine does Wolf suggest? Masssive debt restructuring, And here we get back to the securization mess. It does not mean just writeoffs to banks, but writeoffs to unfortunate holders of asset backed securities of all sorts: credit card, student loan, auto receivables paper, plus MBS. And this is treated as a third rail issue, although the mortgage cramdowns will get us part way there. The US has not been willing to inflict pain on lenders and investors, even though over-their-heads borrowers will go bust and deliver losses. But too many holders of the paper seem to derive false comfort from having the losses show up a tad later than they would anyhow.
Wolf is recommending cleaning out a badly infected wound full of shrapnel before it turns to gangrene. We’d rather take a penicillin shot and hope it clears up. Fat chance.
As grim as that is, China expert Michael Pettis thinks that the US will not be able to run large fiscal deficits for very long (which Wolf indicates is the course of least resistance, and a worse outcome):
What was unsustainable about the current global balance, in my opinion, was not the fact of a US trade deficit (although by 2006 and 2007 it had gotten too high to last very long), but rather the level of household borrowing needed to sustain it. These are not unrelated things, of course, but I would argue that if the US trade deficit had been funded by equity inflows that resulted in an increase in domestic investment, there would not be a trade-sustainability problem. If it was funded by a household borrowing binge, then trade-deficit sustainability is necessarily constrained by the household balance sheets. This is why I have argued that a program of massive fiscal spending to replace household demand is not going to solve the current problem. It simply replaces one kind of unsustainable behavior with another, and still has to be resolved at some point with massive deleveraging.
To get back to China and current issues, the problem with the US trade deficit now is sort of a “Keynesian” problem. US demand has the impact of generating both US production (and employment) as well as foreign production (and employment), and in a world of contracting demand, it is natural that countries that export demand – i.e. trade deficit countries – are going to be a lot less eager to do so. Anything that brings imports closer into balance with exports is likely to have a demand-enhancing impact similar to fiscal expansion, with the benefit that this isn’t achieved by running up fiscal debt. On the other hand it will have a demand-reducing impact for trade surplus countries. That is why trade disputes are likely to be very attractive to trade deficit countries who have – I will continue to insist but it seems recently that this has become a much less “surprising” claim – the upper hand in any dispute with the “virtuous” countries with high savings rates and trade surpluses.
Rather than take any tough measures, the US is opting for expedience, which means only tackling surface aspects of the underlying malaise. We are going down the Japan path when we have much lower savings rates (meaning we cannot handle our problems internally) and less social cohesion.