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Friday, 11 February 2011

This obsession with debt


AT Harvard, I really enjoyed graduate macroeconomics taught by Nobel laureate Prof W. Leonfief and Prof Martin Feldstein. In particular, the philosophies underlying different policy approaches by Keynes, Hayek and Friedman. Simply put, Hayek (the Austrian school ascendant in the 19th and early 20th centuries) promoted the idea that private sector should be left free to find its own balance in a downturn.

The markets' resulting purging power served the United States well in the 19th century when the economy emerged stronger after each recession. But, it was later taken too far in the mix of tight money and high taxes that led finally to the Great Depression. That's when the Keynesian idea of fiscal stimulus took root.

In October 1932, Keynes made the case that depressions are caused by a spending deficit which can only be made up by government spending. Because of “a lack of confidence”, there is no assurance excess funds “will find its way into investment in new capital construction by public or private concerns.” With global recession, the consensus made us all Keynesians resorting to heavy government spending to resuscitate the economy was the answer to severe downturns. First cracks appeared with the outbreak of the fiscal crisis in Greece early in 2010. Critics argued government spending brought-in diminishing returns, producing an anaemic (jobless) recovery that benefited mainly special interest groups.

In the United States, Federal Reserve chairman Ben Bernanke stood steadfast and let it be known more stimulus was needed. His monetary activism led to an open-ended commitment to pump as much money into the system as is required to push for maximum employment. He added that he was doing what Friedman would do.
Milton Friedman advocated that the Great Depression was largely the result of a major contraction in money supply.

Milton Friedman (father of monetarism) advocated that the Great Depression was largely the result of a major contraction in money supply. And could have been avoided had the Fed held money supply stable. There is now growing backlash against the Fed's new approach. As I read it, Keynes would not have supported big deficits during boom times, such as those that led eventually to the 2007/'08 crisis. Similarly, Friedman is unlikely to have backed the Fed's monetary activism in engineering economic expansion rather than merely cushioning the pain in downturns. So, systematic perversion of Keynes' and Friedman's thoughts has led to their falling out of favour once again.


The greatest disagreement between Keynes and Hayek was over benefits of government spending financed by deficits. Keynes pointed out that public interest in a recession cannot rely on private economy went so far as to say: “to spend less money than we should like to do is not patriotic.” But Hayek argued: “The existence of public debt on a large-scale imposes frictions and obstacles to re-adjustment very much greater than that imposed by the existence of private debt.” Simply put, no stimulus is needed. Nevertheless, both agreed this lack of confidence is simply destructive to any weakened economy.

For Keynes, confidence will come by bridging this gap in aggregate demand. “Private economy” was the culprit that impeded a return to prosperity by hoarding savings. That is, the potentially pernicious consequences of an increase in demand for money being not met by a corresponding increase in the supply of money. Even Hayek agreed hoarding is deflationary and “no one thinks deflation is in itself desirable.”

For Hayek, the way forward to building confidence in the face of destructive Smoot Hawley Tariff 30 protectionism, is for governments world-wide, led by the United States, to “abolish all those restrictions on trade and the free movement of capital.” Only expanded trade can rebuild confidence to enable the United States to pay off the public debt.

Growth vs debt

With recovery, albeit anaemic, attention is turned to exit (of stimulus) and fiscal consolidation (bringing down deficits and debt). After more than a decade of good times, the world awakens to face the reality of painful cuts and tax increases which are now needed to restore sanity in public finances, battered by a combination of years of overspending and the effects of global crises.

When recession set in in 2007, advanced nations' budget deficit averaged 1.1% of GDP. By end-2010, this had exceeded 9% according to the IMF, as revenues plummeted and banks got bailed out big time. Government gross debt will exceed 110% by 2015, against 73% of national income in 2007. This global rise in mounting debt will require nations to (i) reduce accumulating debt to bring down debt ratios, and (ii) inject fiscal discipline to reduce deficits. This, the International Monetary Fund warns, means “sizeable and sometimes unprecedented efforts as failing to do so would ultimately weaken the world's long-term growth prospects.”

While this is all well and good, there are fundamental differences in policy on opposite sides of the Atlantic. Germany's finance minister puts it this way: “While US policy makers like to focus on short-term corrective measures, we take the longer view and are, therefore, more preoccupied with the implications of excessive deficits and the dangers of high inflation.”

Last week's Franco-German move to end wage indexation, raise retirement age and lock-in debt limits into national constitutions across the euro-zone is bound to be provoking. In a public lecture, the infamous Soros said: “Something has gone fundamentally wrong in Germany's attitude towards the Economic Union.” By not only insisting on strict fiscal discipline for weaker euro-zone countries but also reducing its own fiscal deficit, Germany was in danger of setting in motion “a downward spiral.” This policy stance ignores a lesson from the 1930s Depression and so is “liable to push Europe into a period of prolonged stagnation or worse. That will in turn generate discontent and social unrest.”

Much of this is already today's reality. President Obama's stance is different but clear: secure a sustainable recovery first, while setting the stage for fiscal consolidation over the near medium-term. Growth is critical to success in reducing budget deficits. The US position is unique in that with US dollar at the heart of the global financial system, it can afford to tighten fiscal policy only when expansion is invigorated. While the US fiscal deficit (10.7% of GDP) is larger than the euro-zone, the Greek and Irish crises have prompted a flight to, rather than from, the US dollar and US bonds. Indeed, there is no market pressure to adjust. So, while the United States recognises it has to seriously tackle problems of fiscal deficit and high debt, there is an unwillingness to act politically.

Is debt too high?

Today's deficits which are leading to ever higher debt and servicing burdens are plainly unsustainable. What level of public debt is appropriate? Conventional wisdom says a safe level in a rich economy is 60% of GDP pitched at the limit enshrined in The Maastricht Treaty which governs membership in the euro. That's before the crisis.

As I see it, there is no empirical evidence to support this limit. Of course, the lower the better since it is unlikely to crowd-out private sector initiative. In the past, this limit was often by-passed anyway. Recent studies by Harvard's Rogoff and Reinhart find that public debt burdens of less than 90% have scant impact on growth; but they see significant impact at higher levels. No one-size fits all.

The United States, with the broadest and deepest bond market and dollar as reserve currency, surely will be able to carry a higher debt than any euro-zone members. In the end, the right level of debt depends on the means used to get there, consistent with growth targets. Evidence shows that cuts in spending are more sustainable and friendlier to growth; whereas, tax increases can harm growth. Taxes that do least harm to growth are on consumption and immobile assets (eg. property). Green taxes also make good sense. But politics often point elsewhere, eg. towards making the rich pay to clean the environment. In UK and US, the highest marginal income tax rates are possibly poised to rise. Good for populists but it will not boost growth.

Debts matter but assets also count 

During the Great Depression, Keynes advocated spending “of any kind, private or public, whether on consumption or investment.” The immediate aim was to urgently fill the void in demand. Hayek took exception for it mattered to him the form spending took since “revival of investment was particularly desirable.” Sure, once recovery comes on-stream, it does matter what the spending is on.

Henry Morgenthau, President Roosevelt's Treasury Secretary, advised: “You can do something about the railroads. You can do something about housing. Above all, you must do something to reassure business We want to see private business expand. We believe much of remaining unemployment will disappear as private capital funds are increasingly employed.” History suggests the new respect for market confidence helped in the recovery following a double-dip in 1937-38. A lesson for US Treasury's Geithner those who forget the past condemn us all to repeat it.

Come to think of it, fiscal consolidation is not just about deficits and debt. Depending on how they are incurred, assets are usually created. It is true we should not burden the future with unproductive debt. All societies have infrastructure assets, i.e. transport, energy & water systems. They also have basic education, health, judicial and defence systems. These systems provide a “public good” which are not usually provided by competitive markets.

Surely, it does not make sense slashing infrastructure and utility investments and support for university teaching when borrowing can be had at absurdly low cost. Indeed, never has there been a better time to borrow than now to productively build public assets. Such Keynesianism is worthy of support especially in the face of large unused capacity.

I think it is wrong to insist that solving the problem caused by debt can't be solved by piling more debt. It's wise to look at net debt. Yale Prof Shiller argues there is “an arbitrage opportunity for governments to borrow massively at these low real interest rates, and invest in positive returning projects Unlike private firms, government can count as “economic profits” on their investments with positive externalities (benefits that accrue to everyone). Of course, unsustainable government consumption must be curbed. Borrowing is no sin so long as they create productive assets. Assets created cannot be ignored when looking at debt.

The Keynesian way

I should end on a lighter note. I well recall a fascination with Keynes' lesser known short essay written in 1930: “Economic Possibilities for Our Grandchildren”. While in the thick of the Great Depression, Keynes reminded us that “the long run trend was inexorable growth.” He then went on to predict ... “the standard of life in progressive countries one-hundred years hence will be between four and eight times as high as it is today.” After 80 years, with all the disasters in between, US and Western Europe are already about 5-times richer. And still counting.

In emerging nations, income growth in the past 30 years has been even more impressive. What's of concern is the quality of sort of growth we are after in the end. Keynes acknowledged the insatiable desire of human beings to blindly pursue wealth. Recent events have shown, even with wealth, people still wanted to borrow more than they could repay. In the end, most would adjust, albeit grudgingly, to a life of plenty. It is in this future good life Keynes famously imagined economists could be thought of as “humble, competent people on a level with dentists.” Economists have a way to go yet.

Former banker, Dr Lin is a Harvard-educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome; email:

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