A vivid debate is currently going between two groups of economists, politicians and financial analysts. One camp argues that government deficits have to be kept within reasonable limits or avoided altogether, because fast-increasing public debt will become unmanageable in the foreseeable future. We wholeheartedly agree.
The other group advocates a continuation of stimulus spending and credit driven investment by governments. In a New York Times op-ed piece published on June 17, 2010, Paul Krugman explained why slamming the brakes on government spending would throw us back into recession. On June 28, he doubled up, now arguing that with reduced government stimulus, we're headed straight towards a new Depression. We fully agree with his assessment.
How come IIER is simultaneously able to agree with two camps which are ready to turn to fists when making their argument? It's quite simple: both have a point. But equally, both have no real answer.
The Keynesian bridge to nowhere
Let's begin with Mr. Krugman, whom one might locate in the deficit-spending, or Keynesian camp. Keynes, in the part that is mostly quoted by the people advocating stimulating consumption and investment by governments, suggests two things. By keeping demand for goods and services high during a recession, the government is able to keep people employed and stimulate further demand by implying a multiplier effect from its spending. At the same time, valuable industrial infrastructure utilization is guaranteed, which ensures that past capital investment is preserved during a downturn, making the conversion to a growing economy smoother, preventing a situation where future growth would be limited by capacity constraints.
We have to say that we fully agree with all the assumptions about those direct implications, in fact, the Post-Keynesian concept of the "multiplier effect" extra government dollars have is very much in line with our own view of the impact growing credit levels have on an economy. But wait. When the concept was introduced in the 1930s, the world stood at the beginning of exploring a bounty of natural resources, first and foremost oil, and what was missing was infrastructure to make good use of those gifts from mother nature. Thus, building cars, roads, machinery and other things made a lot of sense, and had the desired effect of bridging truogh a period of market disturbances after the Great Depression had hit.
Unfortunately, this isn't the 30s, and the problem no longer is the need for meaningful energy applications, but instead the limited availability of energy itself. Or in other words: we don't have too few cars and roads, we don't have enough (cheap) fuels and resources. In a situation like that, all stimulus geared at "kick-starting the growth engine" seems quite futile, as it isn't something to bridge a temporary problem, but a medicine that would be needed in permanence, which isn't feasible. Keynesian-style spending safely puts their advocates into the "exponential growth forever" camp, which is scientifically impossible.
So when Paul Krugman states that government stimulus and deficit spending has to continue until the economy is sound and stable again, we are afraid that this moment of "sound and stable" will never come, for multiple reasons, which include current over-indebtedness of societies as a whole, and energy availability and price problems. If this our assessment is true, bridging this time will lead to nowhere but to unsustainably high government debt.
All this is particularly relevant because adding more debt has been an approach well tested during the past decades, where most advanced economies ended up growing their credit obligations much faster than outputs (GDP). The same was true for government debt, it kept growing as a percentage of GDP in most advanced economies throughout the past 40 years, and started to skyrocket in 2009, based on the mechanisms described above. Government debt, however, has a few characteristics that are very unpleasant. First of all, it comes as a large pool, unlike the thousands of small loans in the private sector, where loan defaults are a relatively harmless corrective mechanism. If the large pool fails, damage is always huge, and will take a significant toll on the attached economy, as all historical examples show. Or even the entire world, if a large enough country defaults on its public debt.
Also, the argument that governments would be able to "print their way out of debt" is a short-sighted one. In some countries, that is technically true, in some (with a rather independent central bank or no central bank with monetary authority on country level such as in the Euro zone) it isn't. But even if a government would be able to issue new money to pay back the old debt, the argument that this would reduce government debt by means of inflation doesn't hold. The reason lies not so much with the government, but with the fact that each inflationary trend will inevitably raise nominal interest rates, even though real interest (net of inflation) might not rise. It will ensure that debt service cost rises for the government, quickly adding to the burden. And unfortunately, in an economy overextended on debt - and most advanced economies fall into that category - already struggling private borrowers will have to pay their interest nominally. Very likely, price and wage increases in an inflationary economy won't be linear, which means that many businesses and people will have to allocate higher and higher shares of their revenues and incomes to debt service. This danger is particularly high if the economy as a whole isn't really growing, e.g. in a stagflation scenario which seems to be a likely one for the foreseeable future.
Austerity - skidding cars don't turn well
Aggregate demand (and with it output measured as GDP) significantly depends on credit availability. While most economic theories somehow ignore that fact, Keynesian economics uses the exact same argument to promote deficit spending. Our own empirical research and models confirm that it is true: growing debt levels immediately stimulate economic growth, and this mechanism does not just apply to government borrowing. All credit expansion directly leads to increasing output. However, in most advanced economies, private sector debt today has reached levels that cannot further be raised despite record-low interest rates, as feasible borrowing maximums have already been reached or overstepped, with loan defaults now correcting some of the excess. In that situation, government borrowing and spending is the last possible support for stabilizing demand. And yes it works: for example, in 2009, transfers between private households and the U.S. government sharply reversed, turning households from suppliers of funds (from taxes, social security payments, etc) to net recipients of government money (from social security payouts, stimulus spending, tax credits and breaks, etc.). Hadn't it been for this reversal, the severe recession that began in 2007 wouldn't have officially ended in 2009.
And now, many people, ranging from scientists to politicians to financial analysts, are getting worried. The example of Greece has given us a feel for what may happen when government spends too excessively, particularly if key creditors are abroad, like this is the case for Greece, Spain, Portugal - and the U.S. People like Niall Ferguson, a Harvard historian looking at financial systems, make a very credible case for using utmost care when applying the spending cure. They claim that once sovereign debt becomes unsustainable - as perceived by markets - this will have far more devastating effects in the future than what fiscal prudence might cause now. And as we discussed above, he has a point. Others, like Carmen Reinhart and Kenneth Rogoff, have analyzed the implications of above-average government debt and of government default, with equally unpleasant results. And yes: all the people in this camp have very valid arguments.
But what happens if governments slam the brakes? There is ample information available regarding that scenario, even from the last two years. Having a look at Ireland, or Hungary, two countries that were simply unable to borrow their way out of the recession like bigger economies, shows what happens. Both experienced significantly declining GDP in 2009. Ireland's gross domestic product tanked by 7.1%, Hungary's by 6.3%, from 2008 to 2009. The sad consequence is that their debt-to-GDP ratios actually worsened during that period, despite them frantically cutting back on government spending. The maths are dauntingly simple: If a country has, for example a 100% debt-to-GDP ratio, a GDP reduction of 5% immediately increases this debt to GDP ratio to 105.3%, even if the government doesn't add a single dollar of new debt.
As this example demonstrates, reducing government spending and thus deficits may have negative effects that work against the original objective of fiscal prudence. On top of that, austerity decisions often get societies into trouble as a whole, as recent riots in Greece demonstrate all too well. Taking a country off debt injections is about as risky as any cold turkey approach on drug addicts.
And now? Recognition, maybe?
So what does all that imply? The spending bridge leads to nowhere, but stopping its construction will advance economies towards collapse. This is exactly what we at IIER consider the biggest problem in the current situation. This is not the 30's, where a bright future of unlimited resource use lies ahead, which is exactly why the Keynesian medicine doesn't cure the patient, it just extends its suffering for a while, with possible disaster further down the road. On the other hand, cold turkey, an immediate withdrawal of the annual infusion of new credit our societies have gotten used to during the past decades, will possibly kill the patient outright, because the attempt to reduce debt might reduce output even faster, which in turn will increase private and public debt burdens relative to GDP.
The situation is unpleasant, as a third, magical option doesn't exist. We have maneuvered ourselves into a corner where there is no more easy and honorable exit. For now, we at IIER consider two things to be most relevant. First of all, simply to buy some time, deficit spending by government has to continue, hopefully in a wiser way than it was done until now. But second, and even more importantly, recognition is required that this actually won't solve the problem, but only gives us room to find the "real solution", which has to be a way to come down from currently unsustainable debt levels in the most benign way possible. If academia and politics would accept that task instead of hoping for eternal growth, this would at least be a start.