Niall Ferguson is not given to understatement. So I was not surprised by the claim last week that the US will face a Greek crisis. I promptly dismissed this as hysteria. Like many other high-income countries, the US is indeed walking a fiscal tightrope. But the dangers are excessive looseness in the long run and excessive tightness in the short run. It is a dilemma of which Ferguson seems unaware.
Ferguson stated that, according to the White House projections, gross federal debt will exceed 100 per cent of gross domestic product by 2012; that the US is forecast never to run a balanced budget again; that monetary policy, not deficits, saved the economy; that higher interest rates are on the way; and, not least, that high fiscal debt is damaging.
Brad DeLong of the University of California, Berkeley, responded that parts of this argument are wrong or misleading: White House projections are for federal debt held by the public to be 71 per cent of GDP in 2012 and not to exceed 77 per cent by 2020; monetary policy would not have delivered even the limited recovery we have had on its own; and higher interest rates may indeed be on the way, but there is nothing in current yield curves to suggest it. Moreover, there is no reason to balance budgets in a country whose nominal GDP grows at up to five per cent a year in normal times.
Short-term benefits
Ferguson is trying to frighten US policymakers out of sustaining or, better still, increasing fiscal stimulus, even though the true issue is longer-term sustainability. He also accuses opponents of believing in a "Keynesian free lunch". Not so. The argument is, rather, that the benefits of the higher output today exceed the costs of debt service tomorrow.
Ferguson believes instead in a conservative free lunch. This is the view that fiscal tightening today would have little effect on activity. Normally, when monetary policy has room for manoeuvre and the private sector's borrowing is unconstrained, that is right. But, as Olivier Blanchard, chief economist of the International Monetary Fund, and colleagues note in Rethinking Macroeconomic Policy, a recent report: "To the extent that monetary policy, including credit and quantitative easing, had largely reached its limits, policymakers had little choice but to rely on fiscal policy."
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The high-income countries that have experienced the biggest jumps in deficits and debts have, inevitably, been Ireland, Spain, the UK and US, as Stephen Cecchetti and colleagues at the Bank for International Settlements (BIS) pointed out in The Future of Public Debt, a paper presented last week at a conference celebrating the 75th birthday of the Reserve Bank of India. These are the countries that had the biggest credit booms and asset bubbles. It is there, as a result, that private-sector spending has been most constrained by the pressure to de-leverage.
Jumps in fiscal deficits are the mirror image of retrenchment by battered private sectors. In the US, the financial balance of the private sector (the gap between income and expenditure) shifted from minus 2.1 per cent of GDP in the fourth quarter of 2007 to plus 6.7 per cent in the third quarter of 2009, a swing of 8.8 per cent of GDP. This massive swing occurred despite the Federal Reserve's efforts to sustain lending and spending. Similar shifts occurred in other crisis-hit countries.
If these governments had decided to balance their budgets, as many conservatives demand, two possible outcomes can be envisaged: the plausible one is that we would now be in the Great Depression redux; the fanciful one is that, despite huge increases in taxation or vast cuts in spending, the private sector would have borrowed and spent as if no crisis at all had happened. In other words, a massive fiscal tightening would actually expand the economy. This is to believe in magic.
Unsustainable
The huge increases in fiscal deficits were appropriate to the circumstances. The only way to have avoided them would have been to prevent prior expansions of private credit and debt. But everybody knows that such deficits cannot continue indefinitely.
Long-run fiscal prospects, largely driven by ageing, are dire. Projecting forward from the dreadful starting points, the BIS authors argue that ratios of public debt to GDP could reach 250 per cent of GDP in Italy by 2050, 300 per cent in Germany, 400 per cent in France, 450 per cent in the US, 500 per cent in the UK and 600 per cent in Japan. If the sovereign debts of high-income countries are not to be reduced to junk, these countries need credible plans for retrenchment.
Now we come to the big dilemma: what if private de-leveraging and fiscal deficits continue in the US and elsewhere for years, as they did in Japan? Then triple A-rated countries, including even the US, might lose all fiscal headroom. This has not yet happened to Japan. It might well not happen to the US. But it could.
So, yes, high-income countries face huge fiscal challenges. And yes, the crisis-hit countries start from grossly unsustainable fiscal positions. But the US is not Greece. Moreover, a massive fiscal tightening today would be a grave error. There is a huge risk in my view, a certainty that this would tip much of the world back into recession. The private sector must heal. That, not fiscal retrenchment, is the priority.
