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     Jun 30, 2010
G-20 splits asunder
By Hossein Askari and Noureddine Krichene

At the Group of 20 summit in Toronto last weekend, the "G" in the G-20 all but disappeared. Irreconcilable differences that were apparent before the gathering were the highlight of the summit, namely, the effectiveness of growing fiscal deficits in restoring global economic prosperity.

Three years into the financial crisis, policymakers and citizens in some G-20 countries have become disillusioned and dismayed by the worsening fiscal picture and the lack of efficacy of unorthodox monetary policies. If the fiscal picture deteriorates much further, it may be almost impossible for a number of countries to climb out of the deep hole without social upheavals.

During much of the past decade, demand policies, supported by large fiscal deficits and negative real interest rates, were blindly implemented in a number of industrial countries. The objective


was to increase demand as the preferred policy of boosting employment. And in spite of the worst financial crisis since Word War II, widespread bankruptcies, and trillions of dollars in government bailouts, demand policies garnered strong and unanimous consensus among the G-20 in the London and Pittsburgh summits and were envisaged as the best way out of the financial and economic crisis, with most of the G-20 countries embracing monumental fiscal deficits never seen before in peacetime, near-zero interest rates, and massive injections of liquidity through the purchase of toxic assets.

This blind unanimity came to a screeching halt before Toronto. Confronted with deepening economic crisis and ruinous public debt, policymakers in Europe have finally questioned the wisdom of these policies. Is granting large salary increases to public servants a sound policy for increasing demand? For some, economic waste, bank solvency and financial safety have had little or no importance. The presumed virtue of demand policies pushed by the US seems to be promoting short-run growth and employment, no matter how disastrous the long run effect.

At long last, European policymakers have discovered that rapidly mounting public spending and fiscal deficits may not be sustainable and could in the end be ruinous for a number of European countries. The public sector cannot simply assume the bad debt of the private sector, and add bailout expenditures to its ongoing fiscal obligations and expect that this would have with no effect on its ability to borrow.

Such expenditures may have to be maintained for many years into the future before full-employment can be reached. All the while, the distortions caused by runaway government spending could be onerous and the financing of government spending could be a challenge: resort to money printing or more and more borrowing, at what cost and what for?

Proponents of Keynesianism see Keynes’ model as the easy way out of a recession, with bigger and bigger fiscal deficits required in the chain of financial and economic crisis that emerge.

In a recent Wall Street Journal article, titled "our agenda for the G-20", White House economic adviser Larry Summers and Treasury Secretary Timothy Geithner praised the success of Keynesianism in fighting the latest economic recession in the US and in the rest of the world and urged their G-20 counterparts to continue down the road to nowhere that they had charted in London and Pittsburgh:
In London last spring, the G-20 embraced an unprecedented and coordinated strategy to end this crisis. In Pittsburgh last fall, we established a new framework for global growth, and we designated the G-20 as the premier forum for international economic cooperation. In Toronto, we will take steps to ensure that the current recovery is self-sustaining. Thanks to strong, decisive and coordinated action, President [Barack] Obama and the other G-20 leaders have achieved significant progress since the London meeting. The global economy, which was then contracting at an unprecedented rate, is now expanding, and world trade has increased by more than 20% over the last 15 months.

This turnaround has been especially dramatic in the United States. At the time of the London summit, the US economy was shrinking at an annual rate of 6%. Now it is growing at a rate in excess of 3% - the largest swing in US growth in 50 years. At the start of last year, the US was losing more than 700,000 jobs a month, and today the private sector is generating new jobs. Recovery was only possible because we took action to repair our financial system, driving down borrowing costs for homeowners, consumers and businesses, and put in place the Recovery Act, which increased demand by cutting taxes for families, helping unemployed workers, and investing in public infrastructure.

To maintain the momentum of the US recovery, we need strong, balanced and sustainable global growth. Global growth will help double US exports over the next five years, supporting several million American jobs, a key goal of the president's export initiative. The G-20 is critical to ensuring that global growth. The G-20 must continue to work together to secure the global recovery it did so much to bring about. We must ensure that global demand is both strong and balanced.

While the US was the major source of demand for the world economic growth before the crisis, global demand must rest on many pillars going forward. That is why the G-20 must support Europe's reform program and the financing that Europe and the IMF [International Monetary Fund] will provide to countries facing acute fiscal challenges. We must demonstrate a commitment to reducing long-term deficits, but not at the price of short-term growth. Without growth now, deficits will rise further and undermine future growth. Emerging economies can help strengthen the global recovery by strengthening domestic sources of growth and by allowing more flexibility in their exchange rates.
The "success" of these policies cheerfully touted by Summers and Geithner for the US and the world economy has been achieved through fiscal deficits in the US exceeding 13% of gross domestic product (GDP )in 2008-2010, a temporary bandaging of the financial system and bank bailouts to hide the real problem (growing debt), and driving down the borrowing costs for homeowners, consumers and business (near-zero interest rates and massive liquidity injections by the US Fed).

What will happen when gigantic stimuli spending are phased out, when deficits become overwhelming, and the burden of debt crushes the hopes and aspiration of future generations? The answer has been provided by Keynes himself: in the long-run, we are all dead, or apres-moi, le deluge.

In Europe, people are still alive and the consequences of fiscal follies are unfolding. In the United Kingdom, elections brought to power a government that is committed to rein in fiscal profligacy. Germany has firmly decided not to stimulate its economy further. France has introduced austerity measures, with Greece, Portugal, and Spain doing the same. Although steps in the right direction, in time, these measures may be seen as insufficient.

Most poignantly, Jean-Claude Trichet, the European Central Bank president, has recently deserted the Keynesian camp. He has argued that tighter fiscal policies are the best way to foster growth in industrialized economies. Firm control of government spending and a rational tax policy were essential for restoring the confidence of households, business and investors. Trichet told the European parliament: "We are in a situation where a lack of confidence is operating against recovery. A budget policy which from a certain point of view you might describe as restrictive is in fact a policy which we would call confidence building." Trichet also urged eurozone governments to beef-up the policing of fiscal policies in the 16-country region and impose tougher sanctions earlier on countries that broke fiscal rules.

The gulf between US and European policymakers has become an ocean. European policymakers are abandoning fiscal profligacy under forced conditions. No matter what they have said to the US, Europeans cannot toe the US line anymore. The US policy design is being rejected.

The US administration is contemplating another stimulus package. Besides stimulating domestic demand, US policymakers have needed to propel exports, which has been promoted by calling on other countries to maintain large fiscal deficits. The US has been urging European countries to show commitment to the G-20 London-Pittsburgh strategy and keep public and private spending rising. Greece and other European countries with large deficits have been urged by the US to maintain their deficits with financing from European countries that are in stronger fiscal positions and the IMF. President Obama has stated that withdrawals from London-Pittsburgh spirit would stall global economic recovery.

Summers and Geithner are politicians. They are only interested in the very short-run. They have been urging G-20 countries, including those who suffer large deficits and debt crises, to maintain fiscal expansion with support from surplus countries and the International Monetary Fund (IMF). Fiscal consolidation should be considered only in a very long run. They want to prove that large government spending is working in creating jobs and full employment will be secured.

The extent of cost, inefficiencies, and distortions of unorthodox fiscal policies did not matter to them. How government debt is to be repaid, what will be the inflationary implications, what will happen when at some point in time when trillions of dollars of government programs are phased out? These issues seem almost irrelevant to Geithner and Summers. European policymakers would hardly be fooled by Summers-Geithner arguments. They have belatedly lost confidence in fiscal extravagance and disavowed the London-Pittsburgh prescription. The markets had lost confidence in G-20 policies much earlier by rapidly deteriorating financial risk measures (the worst since the collapse of Lehman Brothers) and sending gold to record levels in 2009 and recently to close $1,300 an ounce.

The newly emerging market economy countries had to wake up in the 1990s and learn that industrialization based on import-substitution and government protection and subsidies caused decades of economic stagnation. It will take G-20 policymakers years of stagflation before they will admit that large fiscal deficits only accentuate distortions and economic inefficiencies. By trying to fight deflation in August 2007 through large interest rates cuts and massive liquidity injections, the US Federal Reserve pushed the US economy from full-employment at about 4% to mass-unemployment at about 10% in 2009. By forcing interest rates to near-zero bound, the US Fed is encouraging the government to borrow and consume.

The G-20 meeting in Toronto was clearly different from previous G-20 summits. Some governments have awakened to the damage caused to their economies and financial systems by unorthodox fiscal and monetary policies and cannot afford to continue down this path any longer. Exorbitant fiscal deficits and near-zero interest rates are digging their economies into a deeper and deeper hole.

Some economies may crumble when governments withdraw their stimuli or when interest-rates begin to climb. In time, some G-20 countries may discover that they could have gotten out of recession in a shorter time and without incurring huge costs of distortions if they had left the real estate bubble to burst and considered fundamental financial reforms by reducing the role of debt (risk shifting) and leverage in favor of equity financing (risk sharing). For as long as financial institutions assume asset-liability risk, financial crises will be a part and parcel of our economies.

Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.

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