As we begin Samvat 2069, I wonder if the International Monetary Fund (IMF) has started becoming more Keynesian on the issue of fiscal austerity. But before coming to this point, let us take an overview of the mounting problem of fiscal deficits and public debt in the rich countries. As a percentage of gross domestic product (GDP), they are close to the level at the end of World War II.
The US is fast approaching a fiscal cliff as the deadlock on fiscal policy between President Barack Obama’s insistence on increasing taxes borne by the rich to reduce the deficit and the Republicans’ demand for tax reduction to spur growth continues. The latter is a rehash of the so-called, and now mostly forgotten, Laffer curve, drawn on a restaurant napkin showing how growth, and, hence, revenues will pick up after tax cuts. It became the cornerstone of tax policy in the Ronald Reagan presidency. If the deadlock is not broken by 31 December, the tax cuts—imposed during the George W. Bush presidency—will lapse, and public expenditure, particularly on defence, will automatically be cut. The economy could then face a recession in 2013.
To me, what is truly amazing is the argument that the Republicans are fiscal conservatives. The last three decades are replete with evidence that is the exact opposite of this claim: Reagan left huge deficits for his successor, George Bush senior. The latter could not do much about them; his Democratic successor adopted policies which led to a fiscal surplus. This was frittered away by Bush junior through tax cuts for the rich, and his unending war on terrorism in Afghanistan and the invasion of Iraq. The Republican faith in the market also led to the financial crisis of 2008, and President Obama inherited the mess.
Across the Atlantic, the problems of the euro zone are too well known. Last week the Greek parliament did pass the expenditure cuts demanded by the lenders as a precondition to releasing the next tranche of assistance. The big question, of course, is how long will the people of Greece (or the Spaniards for that matter) continue to accept fiscal austerity. A messy break-up of the zone cannot be ruled out in the year ahead. And, a recession is on the cards even without it (also in the UK).
The once miracle economy of Japan has been going nowhere for the last 15 years. Public debt was above 100% in 1997 and has since gone up to more than twice that percentage despite the near-zero interest rates for much of the time. And, despite the ultra-loose monetary and fiscal policies, growth has been uneven and the economy in deflation. Japanese GDP contracted 3.5% in July-September and is suffering external deficits, thanks to an uncompetitive exchange rate. Does the conventional wisdom of the relationship between money supply, inflation and exchange rate not apply to Japan?
The rich countries have also been pumping monetary stimuli in the economy. The US Federal Reserve with its second and third rounds of quantitative easing (QE), the European Central Bank with its outright monetary transactions and the Bank of England with its purchase of government bonds. This can help in financing the public debt without yields shooting up, but what about reducing it as a percentage of nominal GDP? Mathematically, the answer is simple—reduce the growth in the numerator (public debt) below the growth in the denominator (nominal GDP). The former requires growth in revenue and cuts in expenditures (austerity); the latter, higher inflation and GDP growth and productive public investments: not the umpteen bridges to nowhere built in Japan. Actually global growth has been falling since its recovery in 2010, and is forecast to fall further in 2013.
With monetary stimuli and low interest rates not leading to growth, the answer to debt reduction depends on the assumption of what economists refer to as the fiscal multiplier: the ratio between fiscal tightening to the fall in GDP. This was widely accepted to be around 0.5. In other words, fiscal tightening of 1% of GDP would lead to a fall of 0.5% in the economic output. In that case, in the debt-to-GDP ratio, the numerator will fall faster than the denominator; a corollary is that fiscal austerity is the right medicine for the problem of public debt.
IMF’s latest research (Global Economic Outlook, October) suggests that the multiple is between 0.9 and 1.7. (The latter figure is a revision of more than 300% in the earlier assumption.) Other analysts cited by The Economist (27 October) estimate the multiplier to be as high as 2.5 or 3 in recessionary economies. A multiple higher than unity means the ratio of debt-to-GDP will keep growing with fiscal austerity as the highly indebted countries in the euro zone are finding out. The human cost of austerity, mostly borne by the relatively worse off, is another issue.
Will the revision of the multiplier at last convince the proponents of econometric analysis and financial economics (and policymakers) of the fragility of the conclusions their methodology leads to? Once again, John Maynard Keynes seems to be right on the macroeconomic policy issues and in his disbelief of statistical models.
A.V. Rajwade is a risk management consultant, columnist and author.