Martin Wolf, the Financial Times’ influential economics editor, takes issue with the austerity fad that is sweeping governments in advanced economies. From his comment:
Against this background, what would a big tightening of fiscal policy deliver? In the absence of effective monetary policy offsets, one would expect aggregate demand to weaken, possibly sharply. Some economists do believe in “Ricardian equivalence” – the notion that private spending would automatically offset fiscal tightening. But, as Mr Posen argues of Japan, “there is no good evidence . . . of strong Ricardian offsets to fiscal policy.” In developed countries today, fiscal deficits are surely a consequence of post-crisis private retrenchment, not the other way round.
This is all very well, many will respond, but what about the risks of a Greek-style meltdown? A year ago, I argued – in response to a vigorous public debate between the Harvard historian, Niall Ferguson, and the Nobel-laureate economist, Paul Krugman – that the rapid rise in US long-term interest rates was no more than a return to normal, after the panic. Subsequent developments strongly support this argument.
US government 10-year bond rates are a mere 3.2 per cent, down from 3.9 per cent on June 10 2009, Germany’s are 2.6 per cent, France’s 3 per cent and even the UK’s only 3.4 per cent. German rates are now where Japan’s were in early 1997, during the long slide from 7.9 per cent in 1990 to just above 1 per cent today. What about default risk? Markets seem to view that as close to zero: interest rates on index-linked bonds in the France, Germany, the UK and US are about 1 per cent. What, for that matter, does the spread between conventional and index-linked bonds tell us about inflation expectations? We can say that these are, happily, still well anchored, at about 2 per cent in the US, Germany and France. In the UK, they are somewhat higher.
The question is whether such confidence will last. My guess – there is no certainty here – is that the US is more likely to be able to borrow for a long time, like Japan, than to be shut out of markets, like Greece, with the UK in-between.
As borrowers, the US and UK have advantages: first, their private sector surpluses cover some three-quarters and 90 per cent, respectively, of their fiscal deficits; second, many private-sector investors need assets that match liabilities in their domestic currency; third, because these countries have active central banks, bondholders suffer no significant liquidity risk; fourth, they have floating exchange rates, which take some of the strain of changes in confidence; fifth, they have policy autonomy, which gives a reasonable prospect of near-term economic growth; and, finally, the US offers the world’s most credible reserve asset. That gives the US government the position vis-a-vis the world that the Japanese government possesses vis-a-vis Japanese savers.
Critics could argue that these arguments downplay the risks of a “sudden stop” in financial markets. But risks arise on both sides. When Japan – or Canada or Sweden – tightened in the 1990s, a buoyant world economy could absorb excess domestic supply. There is no world economy big enough to offset renewed contraction in Europe and the US. Concerted fiscal tightening could, in current circumstances, fail: larger cyclical deficits, as economies weaken, could offset attempts at structural fiscal tightening. For countries in southern Europe, this is already a danger. Much of the world could end up in a beggar-my-neighbour position towards an increasingly fiscally stretched US…
Premature fiscal tightening is, warns experience, as big a danger as delayed tightening would be. There are no certainties here. The world economy – or at least that of the advanced countries – remains disturbingly fragile. Only those who believe the economy is a morality play, in which those they deem wicked should suffer punishment, would enjoy that painful result.