Reuniting Europe
The Anglo-Saxon Budget Laboratories
Jean Pisani-Ferry
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BRUSSELS – The threat last month of a downgrade of the United States’ federal debt by the rating agency Standard and Poor’s was in a way merely a confirmation of what market participants and observers already knew: US fiscal policy is unsustainable. But the symbolic significance of S&P’s assessment was huge, for it underscored an inescapable truth: worries about public debt that were once confined to a few delinquent countries are now bearing down on the world’s biggest and richest economies.
The message is loud and clear: if the quality of US federal bonds, traditionally the beacon of financial safety, can be questioned, no country is immune from attack. Throughout the advanced world, the question for governments now is not whether it is time to reduce deficits, but how fast, how far, and by what means.
In Europe, German Chancellor Angela Merkel is portrayed as a tough deficit cutter. But while she likes to raise her voice, she acts with caution: today’s German fiscal adjustment is, in reality, very gradual. The countries facing the fiercest budget battles are, instead, the United Kingdom and the US, where fiscal deficits exceeded 10% of GDP in 2010.
In London, Prime Minister David Cameron is on the offensive. Upon assuming office, he entrusted budgetary forecasting to a new, independent Office for Budget Responsibility (OBR), thus forfeiting any opportunity for sleight-of-hand. He then announced a bold consolidation program to cut the cyclically adjusted deficit by 1.5% of GDP per year, thereby targeting a deficit of 3.5% of GDP in 2013.
Cameron’s bet was that this adjustment would stimulate, not hinder, growth. Since Ireland and Denmark showed the way 25 years ago, numerous governments have dreamed of successful “expansionary budgetary contractions.” But a closer look at these oxymoronic, quasi-miraculous episodes reveals that, for the usual recessionary impact of fiscal consolidation to be eliminated or even reversed, at least one of three conditions must be met: households’ precautionary savings decline; long-term interest rates fall; or a more expansionary monetary policy stimulates demand and weakens the exchange rate.
Absent these conditions, budgetary adjustments are almost always growth-reducing, as confirmed by a recent careful and detailed study by the International Monetary Fund.
In the UK, no drop in precautionary savings can be counted upon (households are heavily indebted, so they need to save more, not less), and long-term interest rates are already very low. That leaves only monetary policy to support economic activity. But, owing partly to surging commodity prices and partly to weak productivity gains, UK inflation is higher than expected, and the Bank of England forecasts that at the start of 2012 it will be almost two points higher than the Bank’s own projection last year.
Indeed, the Bank of England’s latest inflation report makes it clear that, in such a context, interest-rate hikes are likely. So it looks increasingly difficult for the UK’s central bank to promote economic growth, which has been stagnant for the two last quarters. Cameron’s bet is not yet won, to say the least.
The US stance has been entirely different. Faced with unemployment close to the post-WWII maximum, Barack Obama’s administration has delayed adjustment in order to avoid smothering recovery. It even gave the economy a further boost at the end of 2010, in part to offset the highly restrictive policies of America’s 50 states, most of which have balanced-budget rules and thus run highly pro-cyclical policies.
To continue stimulating in the short term was a perfectly defensible choice, but it made the lack of any serious thinking about the manner and speed of future consolidation starkly apparent. Until recently, the feeling of urgency that pervades European policymaking was almost entirely absent in the US. There were thoughtful reports, but they lacked any political traction.
A new phase commenced with the recent last-minute agreement to avoid a government shutdown, and the approval by the House of the fiscal program proposed by Republican Congressman Paul Ryan. The budget debate is now in full swing. But the objective remains relatively un-ambitious, and, more importantly, disagreements about the means to achieve it are huge.
The Obama administration is advocating a mix whereby two-thirds of the adjustment comes from spending cuts and one-third from tax increases. The Ryan plan, however, provides for a steeper reduction in spending. It wants spending cuts to be large enough to finance both deficit and tax reduction. The gap between the two camps is vast.
As a result, a kind of war of attrition is now being waged over the US budget. Each side is seeking to use the deficit to push its own preferences regarding the future of revenues and spending, and to compel the other side to back down. Unfortunately, as economists have shown, this is exactly the type of political configuration that leads to delay in budgetary adjustments.
The battle is intrinsically political. The New York congressional by-election at the end of May showed that the electorate cares about public spending. But, as the 2010 mid-term elections demonstrated, US voters also care about taxes. The question is whether they care about the deficit. In principle, they do – at least when asked. But, in practice, it is much less certain that they are ready to choose how to reduce it.
Once again, the UK and the US are acting as laboratories for the rest of the world. The fate of the UK experiment will critically influence other countries’ resolve to embark on large-scale adjustments; the outcome of the US battle will influence choices about the relative priority of spending cuts and tax increases. The results of these experiments will have major consequences for policymakers worldwide.
Jean Pisani-Ferry is Director of Bruegel, an international economics think tank, Professor of Economics at Université Paris-Dauphine, and a member of the French Prime Minister’s Council of Economic Analysis.
Copyright: Project Syndicate, 2011.
www.project-syndicate.org
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RalphMus 06:55 01 Jun 11
Pisani-Ferry’s claim that that “fiscal consolidation” has a “recessionary impact” is not correct.
Deficits have two elements. First there is the structural or cyclically adjusted element, and second there is the part of a deficit that derives from stimulus. Consolidating the stimulus element by definition has a recessionary impact. Consolidating the structural element, by definition, does not.
Consolidating a cyclically adjusted deficit consists (or should consist) of simply reversing the process that brought the deficit into being. Incurring such a deficit consists having government collect an insufficient amount of tax to cover spending, and having it borrow instead. Reversing the process simply involves raising taxes and repaying creditors, which might seem “recessionary”. Actually it is not, and the reasons for this are supplied by Modern Monetary Theory (MMT).
The simpletons who apply microeconomics at the macroeconomic level think that where government has a structural deficit of $X it needs to borrow $X. What MMT says, in contrast, is that the amount of borrowing has to be such that the deflationary effect of the borrowing needs to equal the stimulatory or inflationary effect of the deficit spending. Now given that the deflationary effect of borrowing (I would guess) is far less than the stimulatory effect of government spending, dollar for dollar, this means that a properly implemented structural deficit would involve borrowing far more than $X. Likewise, a properly implemented consolidation of a structural deficit would involve “paying back creditors” or “quantitative easing” to the tune of far more than $X. And since QE is mildly stimulatory, a properly implemented consolidation of a structural deficit should have a neutral effect on the inflation – deflation scale.
Arguably the points I’ve made above are just semantic. That is, my definition of a cyclically adjusted deficit involves no stimulatory or deflationary element at all, whereas Pisani-Ferry’s definition involves mixing a bit of stimulus deficit in with his definition of a cyclically adjusted deficit.
For more on this, see my seminal (??) article here: http://ralphanomics.blogspot.com/2011/05/key-to-deficit-reduction-is.html
Stephan 04:17 31 May 11
>"The message to all governments is clear: if the quality of even US bonds, traditionally the safest of financial assets, can be questioned, no country is immune from attack. So, the question today is not whether it is time to reduce deficits, but how fast, how far, and by what means."
This is another shining example that some economists have no idea what they are talking about which doesn't hinder them to scare the public.
Recall that in November 1998, the day after the Japanese Government announced a large-scale fiscal stimulus to its ailing economy, Moody's made the first of a series of downgradings of the Japanese Government's yen-denominated bonds, by taking the Aaa (triple A) rating away. By December 2001, they further downgraded Japanese sovereign debt to Aa3 from Aa2. Then on May 31, 2002, they cut Japan's long-term credit rating by a further two grades to A2, or below that given to Botswana.
What happened to Japan and the bond market? Nothing. We're still waiting for the bond market attack. The bond dealers simply ignored the know—nothings from Moody's. The Japanese finance minister at the time even told the crooked ratings agencies to take a long walk off a short pier! And what is true for Japan is certainly also true for the US. Thus we can safely ignore S&P and Mister Jean Pisani-Ferry.