By Martin Wolf
Published: November 24 2009 20:17
Financial crises have devastating impacts on the public finances. The impact is also most severe where the pre-crisis excesses were greatest. Among members of the Group of Seven leading high-income countries, this means the bubble-infected US and UK. The question both countries confront is how soon and how far to tighten. Tightening will have to be substantial. But premature action could be a devastating error.
In their work on the history of financial crises, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University note that “the real stock of debt nearly doubles” in crisis-hit countries.* This will be true for the US and UK. It is only in small part the result of bail-outs of the financial sector or of stimulus programmes. According to the International Monetary Fund, in the UK none of the 10.6 percentage point rise in the ratio of fiscal deficits to gross domestic product between 2007 and 2010 will be due to crisis-related discretionary measures.** In the case of the US, 1.8 percentage points of a 6.5 percentage point deterioration will be due to such measures. Most of the change is structural: the levels of GDP and fiscal revenue will not return to the previous path.
How, though, does one assess this fiscal slippage? One way is historical (see charts below). In the case of the UK, the crisis is forecast by the IMF to raise the ratio of net public debt to GDP by close to 50 percentage points between 2007 and 2014. The only comparable previous episodes are wars. The increase this time is smaller than that in the wars with revolutionary and Napoleonic France or the world wars of the 20th century. But it is as large, or larger, than in other 18th-century wars.
This, then, is a unique episode in British fiscal history. That is less true for the US. Again the rise in the debt ratio is comparable to that in big wars – smaller than the second world war, but larger than in the civil war and the first world war. But this is not the first time the US has had a huge increase in its debt ratio in peacetime. The first occasion was under the Republicans between 1981 and 1992. That was when they discovered supply-side economics.
While the increase in the debt ratio is very large in both countries, the levels expected to be reached by 2014 are not historically exceptional, particularly for the UK, where the ratio of public sector net debt to GDP has been close to 250 per cent twice. For the US, debt levels seem likely to match the previous record. Yet, those past record levels did not create insuperable problems. In the 19th century, both countries grew out of their debt satisfactorily, with price stability. In the second half of the 20th century, they did so again, though inflation then helped.
This is not surprising. Assume that the real rate of interest is 2.5 per cent. Then the servicing costs, in real terms, of a debt burden of 100 per cent of GDP is just 2.5 per cent of GDP – almost a bagatelle. Assume, too, that the trend rate of growth equals the real interest rate (a not unreasonable assumption). Then the requirement for debt stability is a balanced primary budget (that is, before interest payments). Again, this is hardly crippling.
So what is the problem? It is that people may lose confidence that the governments will ultimately bring deficits under control. There are at least two reasons for such doubt. First, wars have a natural ending, while deficits in peacetime do not. Second, cutting deficits at the end of wars is easy, while cutting peacetime deficits is hard: every pound or dollar comes with a lobby group attached.
Merely promising to cut deficits lacks plausibility. Aggravating this is the scale of the adjustments. The IMF argues that in 2010, the structural primary fiscal deficit of the US will be 3.7 per cent of GDP and that of the UK 7.8 per cent. The latter is higher than that of any other member of the G7, with Japan closest, on 6.9 per cent (see chart).
The IMF also assumes that it will be necessary to reduce debt ratios to 60 per cent of GDP by 2030, to create the room to respond to new shocks. It concludes that needed US fiscal tightening would be 8.8 per cent of GDP, while that of the UK would be a massive 12.8 per cent. Other advanced countries have made such changes, notably Ireland in the 1980s and Denmark, Finland and Sweden in the 1990s. But it will be a huge challenge, unless one can rely on fast export-led growth. These numbers make nonsense of claims by Gordon Brown, UK prime minister, to have entrenched stability. That is hardly what lies ahead for the UK.
Alas, credibility cannot be taken for granted. That is what the credit default swaps market shows: spreads on UK government bonds have drifted up again, to 70 basis points. I suspect that the reason the ratings agencies have not downgraded the UK may be that if they did so, they would, in logic, have to downgrade the US, too. Which agency would then wish to appear before Congress?
Yet even if the fiscal rope is not infinitely long, slashing deficits now would be wrong. It is extremely likely this would tip economies back into recessions, as happened in Japan in the 1990s. Furthermore, the results would also probably include expansion of quantitative and credit easing by central banks. Yet those policies, too, risk undermining credibility, particularly of currencies, since many investors believe (quite wrongly) that they are harbingers of an inflationary upsurge.
So what should be done? I agree fully with the remark by Dominique Strauss-Kahn, managing director of the IMF, in London this week that “it is still too early for a general exit” from accommodative policies. That applies also to the UK and US. What is needed, instead, are credible fiscal institutions and a road map for tightening that will be implemented, automatically, as and when (but only as and when) the private sector’s spending recovers. Among the things that should be done right now is to put prospective entitlement spending – on public sector pensions, for example – on a sustainable path. It is, in short, about putting in place a credible long-term tightening that responds to recovery automatically.
Yet we also cannot escape from an “inconvenient truth”. Neither the UK nor the US is quite as wealthy as it once believed. There are losses to be shared, much of which will fall on public spending, taxation, or both. Once it becomes evident that neither of these countries can rise to the challenge, fiscal crises are inevitable. It would only be a question of when.
* This Time is Different, Princeton;
** The State of Public Finances, November 2009, www.imf.org
martin.wolf@ft.com
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Copyright The Financial Times Limited 2009
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