A Cautionary Tale of Three Fiscal Crises: Simon Johnson
In today’s world, there are three kinds of fiscal crises brought on by too much government spending, and three kinds of responses. We can call them the nightmare scenario, the preemptive experiment and the head-in- the-sand model.
In the nightmare scenario, a country runs large deficits for a decade or more -- and the financial markets are happy to buy its debt at low interest rates. But then the markets suddenly turn, deciding that the country is going straight off a cliff. The cost of financing the national debt goes through the roof. The government has little choice but to make immediate, large spending cuts.
Higher interest rates combined with cuts in spending contract the economy and increase debt relative to gross domestic product, further undermining market sentiment. The debt ends up largely in the hands of sympathetic governments and the International Monetary Fund, which agree to roll over the loans at low interest rates indefinitely -- or the country defaults. Either way, recovery will take a long time. If you haven’t figured it out by now, this is Greece. In 2010, its debt relative to GDP was 142 percent, or about twice the average of most industrialized nations.
In the preemptive model, a government tries to get ahead of potentially negative market sentiment by bringing down the deficit over a number of years. This slower fiscal adjustment allows smaller spending cuts and revenue-raising measures to work over time. As long as the markets see that politicians are willing and able to bring down deficits, they should be greatly reassured.
This particular government has a secret weapon -- a free- floating exchange rate -- not available to Greece or other euro zone countries. If the currency depreciates, it will help the economy by increasing exports and tourist spending, and will boost sectors that compete against imports. The central bank can also cut interest rates. Inflation may be a constraint on monetary policy, but moderate increases in prices and wages will help keep house values up and consumer debt down, relative to disposable income.
This model, of course, is Britain. Its spending cuts are relatively small, and although its fiscal policy is contractionary, the overall policy mix remains expansionary. The key dynamic in the eyes of the market is debt relative to GDP, so the trick is keeping up economic growth while debt comes under control. With most growth predictions in the range of 1.5 percent to 1.9 percent for this year, and 2.1 percent to 2.5 percent next year, the consensus view is that fiscal policy will not push the U.K. back into recession. Britain’s gross debt should peak at 87.4 percent of GDP in 2013, according to the IMF.
In the head-in-the-sand model, the political debate around the deficit is more about symbols than reality. The main political parties refuse to take seriously the need for new revenue. At the end of last year, instead of cutting spending or raising taxes, they recklessly agreed to extend costly tax cuts. And no one wants to deal sensibly with government-funded health care, the biggest future spending item of all.
This is the United States. The IMF does not like to appear critical of the U.S., so you need to dig deep to find its negative assessment, on Page 127 in Statistical Table 7, of the fund’s authoritative Fiscal Monitor, published in April. It says gross debt will increase through the end of the forecast horizon in 2016, when it will reach 111 percent of GDP. That’s about the nastiest thing you can say about a country in today’s market environment.
The problem is not that this fiscal trajectory will precipitate an immediate crisis, but that savers around the world will continue to give the U.S. enough rope to hang itself. Interest rates are likely to remain low as long as there are no other equally attractive reserve currencies. Foreign central banks and private investors like to keep their rainy day funds in U.S. Treasuries.
The U.S. should take this opportunity to start gradual fiscal consolidation, not Greek-style spending cuts that would contract the economy and push up government debt relative to GDP. A path slower than Britain’s would be entirely reasonable, restricting future spending increases and allowing revenue to rise as the economy recovers. A credible deficit reduction plan should lower long-term interest rates.
The danger in the U.S. is complacency masquerading as fiery fiscal rhetoric. The debt limit debate so far has not contributed anything to fiscal stability. The spending limits on the table are largely meaningless. Ruling out tax increases makes international investors roll their eyes.
The U.S. could do a preemptive, and relatively gentle, fiscal adjustment. Or it could wait for the nightmare scenario, when markets eventually turn against it. At the moment, the politicians just wait.
(Simon Johnson is a Bloomberg View columnist. The opinions expressed are his own.)
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