Wednesday, June 23, 2010


Martin Wolf

Festina lente – hurry slowly – is advice we have inherited from the ancient Romans. Western policymakers should now take it to heart. Confronted with huge fiscal deficits, many have concluded that they should hurry fiscal tightening on as fast as possible, in the hope that it will prove expansionary. What are the chances that they will be right? Small, I believe. Moreover, rather better alternatives are on offer. But their drawback is that they are unorthodox: alas, many “sound” people prefer orthodox recessions to unorthodox recoveries.

Why might a sharp structural fiscal tightening promote recovery? As Harvard’s Alberto Alesina and Silvia Ardagna note in an influential paper, smaller prospective deficits may improve confidence among consumers and investors, thereby raising consumption and lowering risk-premia in interest rates.* Meanwhile, on the supply side, fiscal tightening may increase supply of labour, capital or entrepreneurship. The broad conclusions of their paper are that fiscal adjustments “based upon spending cuts and no tax increases are more likely to reduce deficits and debt over gross domestic product ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions.” This line of argument has strengthened the will of George Osborne, the UK’s new chancellor of the exchequer.

Is it persuasive? In a word: no. The authors group together data for members of the Organisation for Economic Co-operation and Development between 1970 and 2007. But the impact of fiscal tightening is going to depend on circumstances.

A reduction in the fiscal deficit must be offset by shifts in the private and foreign balances. If fiscal contraction is to be expansionary, net exports must increase and private spending must rise, or private savings fall. Thus, experience of fiscal contraction is going to be very different when it occurs in a few small countries, not in many big ones simultaneously; when the financial sector is in good health, not impaired; when the private sector is unindebted, not highly leveraged; when interest rates are high, not close to zero, when external demand is buoyant, not feeble; and when real exchange rates depreciate sharply rather than remain fixed.

In short, when, as now, the economies affected by financial sector fragility make up half of the world economy (indeed, together with the still feeble Japanese economy, close to 60 per cent); when the most dynamic large economy in the world – China – is mercantilist; when interest rates are near zero; and when businesses and households are credit-constrained, the view that an early fiscal tightening will prove strongly expansionary is surely heroic. I hope it will be true. But there is little reason to believe it.

Another study, by the US Committee for a Responsible Federal Budget, examined the cases of Canada, Denmark, Finland, Ireland and Sweden. What emerges is the importance of external demand and, in several cases, of huge exchange rate depreciations (see chart). Are these successful examples really relevant to the US and European Union today? I very much doubt it.

Yet another approach is to find a situation that is indeed quite like today’s. The closest parallel is the 1930s, in terms of the proportion of the world economy affected by the crisis, the low interest rates and the disinflationary (or, in that case, deflationary) background. A study published last year concluded that fiscal stimulus was effective when tried.** It follows that fiscal tightening would have been – indeed was – contractionary at that time.

In current circumstances, the belief that a concerted fiscal tightening across the developed world would prove expansionary is, to put it mildly, optimistic. At this stage, I will inevitably be asked: what is the alternative? If these huge deficits continue, markets will take fright, interest rates will jump and the debt dynamics will become truly awful.

I have two responses to this.

The first, one I made a week ago, is that the deleveraging cycle is generating huge private sector financial surpluses across the developed world. Unless we expect a shift into aggregate external surpluses (and corresponding deficits in the emerging world), these surpluses must now to be invested in government liabilities. This helps explain why yields on the bonds of safer governments remain so low.

The second response is that if governments need to run deficits, to support demand at a time of private sector weakness, they can always borrow from central banks. Yes, this is “printing money”. It is also an insanely radical policy recommended by no less insane a radical than Milton Friedman, back in 1948. His view was that the government could expand the money supply during recessions and contract it in the subsequent booms. A country with a fiat currency and a floating currency could, thus, stabilise the economy without destabilising credit markets. The neat thing about this proposal is that one does not have to decide whether fiscal policy or monetary policy is doing the heavy lifting: they are two sides of one coin.

The argument for aggressive monetary expansion remains strong, though not equally everywhere, since the growth of broad money and nominal GDP is weak (see chart). So Friedman’s policy of “quantitative easing”, as it is called, still makes good sense. Am I recommending the economics of Robert Mugabe? No. As in everything else, it is the context that matters. At present, we have “too little money chasing too many goods”. In this environment, monetary policy must be aggressive. When the economy recovers, the monetary effects should be withdrawn, via budget surpluses obtained via long-term control over spending. In the short term, changes in reserve requirements can offset the impact on monetary expansion of the rise in deposits of commercial banks at the central bank. Since, in practice, the money supply is driven more by the demand for credit than reserves, this may be unnecessary.

The conventional wisdom is that a strong and co-ordinated structural fiscal contraction, focused on spending, will promote the growth of a thousand private blooms. I hope this will prove true. But I doubt it. Governments should hurry slowly. If they all hurry quickly, they – and we – may regret it nearly as soon.

* Large changes in fiscal policy, working paper 15438,
** Almunia et al, The effectiveness of fiscal and monetary stimulus in depressions,

No comments: