Page 1 of 3 Austerity fails policy test
By Henry CK Liu
There is an undisputed general law in public finance that sound fiscal policies
must precede a sound currency. What is in dispute is what constitutes a sound
fiscal policy. Neo-liberals deem recurring fiscal deficits as signs of unsound
fiscal policy. Yet over the multi-year duration of most recession phases of
business cycles in market economies, multi-year deficit financing to stimulate
economic activities in a recession can be a very sound fiscal policy.
Under such circumstances, a balanced annual budget would be quite the opposite
of a sound fiscal policy. Still, some recessions may take more than a decade to
recover, even with persistent fiscal deficits if the funds are spent on wrong
targets, as in the
case of Japan after the Plaza Accord of 1985.
In Japan after Plaza Accord, the fiscal deficit did not help the Japanese
economy because it had been spent on the wrong targets. Realistically, reducing
the debt/GDP (gross domestic product) ratio is difficult with only fiscal
reform: the economy must also be on a growth path.
As the fiscal deficit widens, the Bank of Japan bought up larger amounts of
government bonds to avoid disruption in the government bond market. In this
sense, Japan today resembles post-World War II United States, where the Federal
Reserve implemented a bond price support policy to keep interest rates low.
Moreover, just as the exchange rate of the dollar was not damaged by Federal
Reserve policy of bond support to keep interest rate low, the bond-buying trend
in Japan has not lowered market confidence in the yen. Similar to the US in
that period, Japan is a creditor that enjoys a persistent current account
surplus. Thus Japan has the strength to ward off market challenges to
confidence in its currency despite the mounting government debt financed by the
central bank.
US policy after World War II was to buy government bonds by quantitative easing
to check rampant rise in public debt, and to leverage economic growth for a
soft-landing of the debt/GDP ratio. Japan today is similar in that the Bank of
Japan is buying a limited amount of government bonds, but differs in that it
shows no signs of halting growing debt and is falling into deflation and
economic stagnation.
Quantitative easing (QE) describes a central bank monetary policy to increase
the supply of money in an economy when the bank interest rate, discount rate
and/or interbank interest rate are either at, or close to, zero.
A central bank does this by first crediting its own account with money it has
created ex nihilo (out of nothing). It then purchases financial assets,
including government bonds and corporate bonds, from banks and other financial
institutions in a process referred to as open market operation. The purchases,
by way of account deposits, give banks the excess reserves required by them to
create new money by the process of deposit multiplication from increased
lending in the fractional reserve banking system. The increase in the money
supply thus stimulates the economy. Risks include overeasing, spurring
hyperinflation, or the risk of not being effective enough, if banks opt simply
to pocket the additional cash in order to increase their capital reserves in a
climate of increasing defaults in their present loan portfolio. The latter
seems to be what has happened in 2009 in US banks.
Post-Napoleonic War England shows that fiscal deficits can be cut even under
deflation. In England's case, however, improved productivity after the
industrial revolution and the subsequent population increase generated high
growth that more than offset deflation and helped lower the debt ratio. Japan,
however, suffers not only low growth but also population decline; reducing the
debt/GDP ratio under deflation seems unrealistic. The US economy will face
population growth problems if current anti-immigration sentiments continue.
Coupled with slow growth, the US economy will face many of the same problems
faced by Japan it her lost decade.
As in the US, Japanese citizens share a sense of urgency regarding Japan's
fiscal health. In a public opinion poll, 60% of respondents already think that
"raising consumption tax is unavoidable to maintain the social security system"
(Yomiuri Shimbun, November 2009 survey). Behind such opinion is the heightened
sense of crisis concerning Japan's deteriorating fiscal health following the
Lehman Brothers bankruptcy shock; stronger understanding that new financial
resources are necessary to improve child-rearing support and impoverished
healthcare; and the reality that even "budget screening" will only produce
marginal revenue. Recent media coverage juxtaposing Greece's crisis with
Japan's fiscal situation may also be contributing to public awareness. Yet the
US, unlike Japan, does not enjoy a trade surplus to tap the consumption of
other economies to cushion a reduction of its own fiscal deficits spending.
Japan's 2009 government debt ratio is on par with post-Napoleonic War England
(accumulative long-term debt reached 171% of GDP). The government bond market
survives because almost all of the bonds are denominated in yen and held
domestically (about 95%), and there is significant political room to raise
taxes in the future.
Japan's current 25.1% tax burden ratio (fiscal 2008) is low compared to
European countries (England 37.5%; France 37.6%; Sweden 51.5%), and the
possibility of a consumption tax hike is particularly high. If citizens
recognize that their tax burden is low and accept a higher consumption tax
there is no reason why the government bond market should collapse from worries
over bond redemption. As society ages and the savings rate falls, however,
Japan does face a gradual decline in its capacity to absorb government bonds.
Of course, to reduce the debt ratio Japan must not only raise taxes but also
shake free from deflation and embark on an economic growth track (high nominal
growth that yields a degree of inflation). Japan is fortunate to be in
proximity of rapidly growing emerging markets such as China, affording it great
potential to maintain growth by maximizing such demand. Whether Japan can
really leverage this demand is unclear, but the potential leaves the door open
to fiscal reform.
While Japan's fiscal situation is therefore severe, there are paths towards
improvement such as tax increases and growth. The issue is whether there is the
political will to stanch further fiscal deterioration and make tax hikes and
growth a reality. Absent a show of government will in this direction, the
market will focus only on the negatives such as a falling capacity to absorb
government bonds and difficulties in spurring growth and raising taxes.
Japan will be expected to become a deficit country even if it enjoys a current
account surplus at that point. Of the forces that pressure the government
towards fiscal prudence, market pressure such as rising long-term interest
rates should come into play.
Moderate pressure from the market notwithstanding, Japan will likely end up
raising taxes and address the problems without inviting disturbance in the
market. The Bank of Japan will then need to provide financial support to foster
an environment favorable to realizing high growth.
The situation in the EU
In March 2005, the European Union's Economic and Financial Affairs Council
(ECOFIN), under the pressure of France and Germany, relaxed the rules to
respond to criticisms of insufficient flexibility and to make the pact more
enforceable. Permissiveness infested the theoretical regulatory framework at
the boom phase of the business cycle.
At the urging of Germany and France, the ECOFIN agreed on a reform of the
Stability and Growth Pact (SGP). The euro convergence criteria as spelled out
in the SGP are:
1. Inflation rates - No more than 1.5 percentage points higher
than the average of the three best performing (lowest inflation) member states
of the EU.
2. Government finance
a) Annual government fiscal deficit - The ratio of the annual government fiscal
deficit to gross domestic product (GDP) must not exceed 3% at the end of the
preceding fiscal year. If not, it is at least required to reach a level close
to 3%. Only exceptional and temporary excesses would be granted for exceptional
cases.
b) Government debt - The ratio of gross government debt to GDP must not exceed
60% at the end of the preceding fiscal year. Even if the target cannot be
achieved due to the specific conditions, the ratio must have sufficiently
diminished and must be approaching the reference value at a satisfactory pace.
3. Exchange rate - Applicant countries should have joined the
exchange-rate mechanism (ERM II) under the European Monetary System for two
consecutive years and should not have devaluated its currency during the
period.
4. Long-term interest rates - The nominal long-term interest rate
must not be more than 2 percentage points higher than in the three lowest
inflation member states.
The ceilings of 3% of GDP for budget deficit and 60% of GDP for public debt
were maintained, but the decision to declare a country in excessive deficit can
now rely on certain parameters: the behavior of the cyclically adjusted budget,
the level of debt, the duration of the slow growth period and the possibility
that the deficit is related to productivity-enhancing procedures.
The pact is part of a set of Council Regulations, decided upon the European
Council Summit on March 22-23, 2005. Having adopted unneeded permissiveness at
the boom cycle, Germany is now leading the charge to reduce fiscal deficits in
eurozone by promoting austerity programs in every eurozone member state in the
midst of a severe recession.
The curse of IMF conditionalities
The problem with the International Monetary Fund (IMF) "conditionalities" cure
in a sovereign debt crisis is its insistence on a balanced fiscal budget at the
wrong time - during a monetary-induced recession - thus adding to the economic
pain unnecessarily and assigning disproportional burden on the most defenseless
segment of the population (the working poor), and condemning the impaired
economy to an unnecessarily long path toward recovery.
Some are concerned that long-term Federal debt may balloon up to 180% of GDP.
While this development should be arrested by fiscal prudence, that is perhaps
only half of the solution. The other half is to direct the fiscal deficit
toward GDP growth. Sometimes a large fiscal deficit can help actually reduce
its share of the GDP if the fiscal deficit generates a bigger GDP.
The Federal fiscal deficit in 1919 was 16.8% of a GDP of $78.3 billion. The war
time Federal deficit in 1945 was 24.1% of a GDP of $223 billion. Despite a high
fiscal deficit, US GDP kept rising after war to $275.2 billion in 1948 with a
fiscal surplus equaling 4.3% of GDP. The 2010 Federal deficit is projected to
be 10.6% of a GDP of $14.6 trillion.
Between 1920 and 1929, the Federal budget had a small surplus, while GDP grew
to $103.6 billion in 1929. After the 1929 crash, the 1930 GDP fell $12.4
billion, about 12%, to $91.2 billion, while the Federal budget under Hoover
still had a surplus of 1% of GDP.
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