Alternative Fiscal Medicine?

BRUSSELS – Forget the fiscal cliff. The real issue is the fiscal mountain. According to the International Monetary Fund, the challenge of reducing the public debt/GDP ratio to a safe level is daunting for most advanced countries.

In Europe, many governments, having embarked on the path of fiscal consolidation while their economies were still weak, are now struggling with the growth consequences. As a result, debt stabilization seems to be an increasingly elusive target.

In the US, consolidation has barely begun. Because the private economy is now stronger, it may benefit from more auspicious growth conditions, but the magnitude of the fiscal retrenchment needed – more than ten percentage points of GDP, according to the IMF – is frightening. In Japan, nothing has been done thus far and the size of the required effort defies imagination.

All advanced-country governments are still officially committed to undergoing the pain of adjustment. But how many will become exhausted before implementing this program in full? Willingly or not, some may seek recourse to inflation or administrative measures aimed at trapping domestic savings into financing the state and keeping bond rates low (what economists call financial repression) – or, eventually, to outright debt restructuring.

All three unorthodox remedies have been used in past debt crises. They can be regarded as alternative forms of taxation, albeit implicit rather than explicit. In the end, they are different methods of forcing current and future generations to shoulder the burden of accumulated debt.

Is it preferable to adjust in full? Or is it advisable to blend consolidation with a dose of alternative medicine?

Here, the discussion is often couched in moral terms. Adjustment, we are told, is morally commendable, whereas the alternatives all amount to repudiating the contracts that governments entered into with bondholders.

This may be true, but governments are political animals. They care more about voters’ welfare than about moral principles. So it is worth discussing in purely economic terms what orthodox and unorthodox choices imply from the standpoints of equity and efficiency.

Start with equity. From this perspective, adjustment is hard to beat. Combining taxation and spending cuts allows the burden of adjustment to be distributed precisely. The decision belongs to the legislator. Some adjustments, like in France nowadays, weigh mostly on high-income, high-wealth individuals; others, like in Italy, weigh on pensioners. These choices were made democratically, in parliaments, as part of budget decisions.

The unorthodox techniques, however, are less nimble and more opaque. Inflation affects those with assets (cash, bonds) or incomes (wages, income from saving accounts) that are not indexed (or are under-indexed) to prices. Financial repression is basically a form of administrative taxation of domestic savings. And restructuring is a levy on bondholders’ wealth, including that of middle-class pension savers. On distributional grounds, there does not seem to be a good reason to resort to them in lieu of relying on outright taxation.

There are exceptions, though. First, governments and parliaments may be politically unable to take responsibility for distributional choices and prefer to keep them hidden. This is not a good reason, but it does happen.

Second, restructuring concentrates the burden on those holding bonds issued before a certain cut-off date. It thus draws a line between the past and the future – leading to what John Maynard Keynes called “euthanasia of the rentier.” When the burden of past turpitude is too heavy, there may be no other way to protect future generations.

Finally, both inflation and restructuring put some of the burden on non-resident bondholders (through exchange-rate depreciation and the direct reduction of the value of assets, respectively). For taxpayers, this is a tempting formula, especially when a large share of the debt is held externally. To make foreigners pay is, however, disputable. After all, they were not the beneficiaries of the public goods or transfers financed by the issuance of debt. So it should be reserved for cases when the country as a whole has grown insolvent.

Turn now to efficiency. Large-scale adjustments may leave an economy with a weaker capacity to generate growth, because high taxes have deterred investment or cuts in public spending have eroded the quality of infrastructure and education. But this is true of the unorthodox remedies as well.

Financial repression distorts choices by channeling savings to budget financing and away from investment. Inflation implies higher long-term interest rates until markets regain confidence in the central bank. And restructuring weakens banks, which generally hold large portfolios of government bonds, thus making them less able to finance the economy. Indeed, restructuring undermines the foundation of the entire financial system: the safe-asset role of sovereign debt. As developing countries have learned from experience, all these effects are bad for capital allocation and growth.

But an exception can again be made: When both the private and public sectors are overburdened with debt, adjustment leads to a debt-deflation spiral, particularly when conducted under a fixed exchange-rate regime. In such conditions, full adjustment risks becoming self-defeating, or at least unreasonably painful, as illustrated by the Greek case. Despite their economic costs, restructuring public debt or eroding all public and private liabilities through inflation can be less detrimental options.

In the end, the alternatives to adjustment are not soft. Barring extreme situations, they generally underperform fiscal adjustment from the standpoint of equity, and are no better in terms of efficiency. So the idea that they offer an easy way out of advanced countries’ current predicament is a fantasy.

Rather than flirting with illusions, governments should confront the hard choices ahead of them. Relying on alternative remedies is sometimes necessary, but they are not painless. They should be considered treatments of last resort.