Saturday, June 19, 2010

FISCAL STIMULUS AND SOVEREIGN DEBT: A POLICY DILEMMA









In my last post I stated the paradox that the growth of the Welfare State, so closely related to the spread of the Keynes’ ideas, has sapped the potency of Keynesian fiscal stimulus. Keynesian economics can more readily stabilize the classical night watchman state than reverse a downward spiral of the mixed economy.







In this post, I examine the dilemma of using policy to stimulate our (US and European) economy. Private spending has declined and private saving has increased dramatically since the financial meltdown of 2008. In order to counteract its contractionary force, Keynes prescribed that government dis-save and spend more, which increases government debt. The probability of default rises with the size of debt and recedes with economic growth.







The Dilemma







The dilemma is this: Fiscal stimulus spurs growth, which improves the capacity of government to service debt, but also increases debt, which in extremis can push up default risk to a point where private agents will not lend to government. At that point fiscal policy breaks down. The higher the initial debt, the more dominant will be the latter effect. So, push on the fiscal lever and risk a government debt crisis or lay off it and risk stagnation, and the possibility of a government debt crisis. Greece has passed the tipping point. Much of the rest of Europe is near and nobody can be sure how far away is the US.







Keynes famously satirized the British government in depression: “They say they cannot spend because they do not have the money, but they have not the money because they will not spend”. But the UK did not face a borrowing constraint in the 1930’s. It may be near one today.







As I pointed out in my last post, this argument is not founded on any notion that government debt ‘crowds out’ private investment when the economy is in a slump. It accepts the idea that a market economy can be stuck in a position of low capacity utilization. Even so, people will not lend to a sovereign they fear will default.







Some commentators, notably Paul Krugman, will not countenance that we may be near the practical limits of government debt capacity. His sanguinity is contradicted by the historical record of sovereign default in the wake of financial crises.







A Solution?







Martin Wolf has laid out, in a series of essays in the FT, a persuasive case for threading the needle by pursuing fiscal stimulus now, with the promise of austerity once the economy has recovered. This ‘jam today’ policy would calm the bond market fears of government insolvency and thereby enable sovereigns the unimpeded access to private savings required for fiscal stimulus. It is an elegant solution to our dilemma: Borrow to meet the short term emergency and wind down the bloated public sector after the storm has passed, when far fewer people are reliant on public support.







A Fatal Flaw







For Wolf’s idea to work, however, investors would have to be convinced that Europe and the US will roll back the Welfare State. Is that a reasonable prospect? The social compact of the urbanized/industrialized world since the Great Depression and WWII has been founded on a growth in social insurance. To reverse that will require a tectonic shift of a type that usually follows a social and economic crisis, but Wolf’s idea is intended to avert such a crisis; Another dilemma.







Naturally, today’s government leaders will promise future austerity if that will gain them access to funding, but they cannot bind what tomorrow’s leaders might do. That is the rub that makes rubes out of investors who believe it.







We are adrift.

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