FINANCE & ECONOMICS

Buttonwood

Paying the price

Dec 30th 2009
From The Economist print edition

Choosing between workers and creditors

Illustration by S. Kambayashi

THE air of immediate crisis is over. The monetary and fiscal doctors wheeled out the crash trolley and applied an electric shock to the global economy’s chest. The patient is recovering but is still rather too dependent on the drug of government support. The coming year will be dominated by a debate about how quickly that support can be taken away.

Two shocks have reduced the standard of living of Western economies. One is a terms-of-trade shift. Thanks mainly to China, the prices of the manufactured goods that rich countries sell have fallen; those of the commodities they buy have risen. The other is a “leverage” shock, in which the credit crisis has stopped people from borrowing to finance consumption.

In response to this second shock, governments have deliberately taken on the debts of the private sector. In most cases it has been assumed that governments have almost limitless capacity to assume such burdens. But you can see welfare states as national Ponzi schemes in which governments grant benefits and take on spending responsibilities, confident in the expectation that the next generation of citizens will pick up the bill.

Such promises have worked so far because of continued economic growth and rising populations. But with populations starting to fall in some countries, and the tax base shrinking in others, the strain is starting to show. The financial crisis has piled on further stress. Iceland, a tiny island state, was overwhelmed by the debts of its banks. Dubai has shown that the distinction between government debt and the debt of government-controlled entities can be a fuzzy one. Greece has been downgraded by two rating agencies, Fitch and Standard & Poor’s.

All this may lead to a turbulent year in the currency markets. The idea of the “law of volatility” is that you can control risks in some parts of the system but not in them all. A zero-interest-rate policy has supported risky assets, particularly equities, while quantitative easing, by allowing central banks to buy government bonds, has prevented massive fiscal deficits from pushing up bond yields.

But having taken those two steps the authorities cannot also prop up their currencies, even if they had the desire to do so. In the absence of inflationary pressure, a depreciating currency seems a painless way of boosting the prospects of a country’s exporters. So the American and British authorities have been happy to let the dollar and sterling slide.

Of course, not all currencies can depreciate. Some must rise. By rights this should be those of the emerging Asian economies. But China in particular is unwilling to let the yuan appreciate as fast as the markets, or its trading partners, would like. That puts even more pressure on the losers in this game of deflationary pass-the-parcel. Brazil has reimposed a levy on capital imports to weaken the real. Japan’s new government has been pressuring the central bank to ease monetary policy further in the face of the strengthening yen.

In Europe the single currency has removed the old escape route of devaluation. Countries that have seen faster-than-average cost growth must accordingly face years of austerity if their manufacturing sectors are to remain competitive against Germany, let alone Asia.

But will electorates be willing to swallow such unpleasant medicine? The temptation, as in Britain, is to attempt to solve the crisis by raising taxes, rather than cutting spending, especially if those taxes can be aimed at an unpopular group like bankers. However, a high-tax strategy in a world of highly mobile labour and capital seems doomed to failure in the long run. The pain is likely to fall on the broad mass of the population.

The battle then is between taxpayers and public-sector workers, with the former broadly represented by right-wing parties (the Republicans in America, the Conservatives in Britain) and the latter by left-wing ones (the Democrats and Labour). Even if the right-wing parties win the argument in the legislature, they could still lose on the streets, if strike action forces governments to back down.

The gold standard broke down in the 1930s because countries would not pay the political price, in the form of austerity, to maintain the link. They chose domestic workers over foreign creditors. The Bretton Woods system broke down because America was unwilling to bear the burden of being the linchpin of the system. Now, the system that prevailed in the 1980s, 1990s and 2000s, in which creditors trusted central banks to maintain the value of debtor countries’ currencies, is breaking down as well.

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