You think you have choice between deficit or recession; you will have deficit and recession

This is a contribution to the FT debate about “to tighten or not to tighten” in July 2010. Reply to Mr. Skidelsky, M. Kennedy and the others

Keynes wrote in 1937 “the boom not the slump is the right time for austerity” then why do we never heard Keynesian Economists warning us in time of growth (not necessarily boom) that the rich countries governments were wrong to run systematic structural deficits for years, if I take IMF WEO data, we find that most OECD countries were every year in structural deficit from 1980 (starting year of statistics): Spain, Greece, France, Italy, Japan, Belgium, Ireland; what about the virtuous Germany? Structural deficit from 1980 to 2010, except in 1989. USA, structural deficit from 2002 (no data before), UK structural deficit from 1980-1997, structural surplus1998-2001, structural deficit 2002-2010. Keynesian Economists would be more credible if they had told us during the boom years that fiscal policies of rich countries was non sustainable, they did not say anything, on the opposite. What is the result of permanent structural deficit? An unsustainable public-debt level which prevents these countries to run a Keynesian policy in time of downturn.

France had a deficit 30 years (since 1980) out of 30 and for no reasons. In the graphic n°1 we have two quadrants, the right one with real growth rate (g) with a positive value and an fiscal balance negative, this quadrant represents a pro cyclical fiscal policy. We can notice that all the years from 1980 (except two) are located in the quadrant growth with fiscal deficit, France fiscal policy is definitely pro cyclical. During Mitterrand presidency (1981-95), the fiscal balance was always negative and above 3% of GDP with a positive rate of growth six years out of 14. During the Chirac years (1995-2007), the fiscal deficit was above 3% of GDP with a positive rate of growth, six years out of 14, same score between the left and the right, both did not give a damn for fiscal rectitude, their slogan: “après moi le deluge”.

Source: IMF WEO, 2010

The “virtuous” Germany has, like France, a pro-cyclical policy, almost every year, Germany has a positive rate of growth with negative fiscal balance.

Greece ran a fiscal deficit above 5% of GDP from 1981 to 1997 and from 2003 to 2005 and a deficit above 3% of GDP during the whole period, the result of this “Keynesian” policy? Go to see Mr. IMF.

UK had a surplus five years out of 30. The fiscal deficit was above 3% of GDP with positive growth during the period 1983-84, 1992 to 1996 (John Major), from 2003 to 2005 (Tony Blair) and 2008-10.

US deficit above 3% of GDP with a positive rate of growth during the period 2002-2005 , (G.W. Bush, President).

If we look at Canada, this is the opposite, from 1990 (no data before) to 1996, Canada runs a pro-cyclical fiscal policy, then from 1997, Canada has a countercyclical policy, fiscal surplus every year (except in 2009, year of recession).

Netherlands has since 1995 a fiscal deficit above 3% of GDP only in 1995 and 2003 (with positive growth).

What the Keynesians miss, is that this present time is not the same as Keynes’ time. Why? Because we have systematically applied a Keynesian policy without understanding the consequences. The public expenditure ratio of developed countries is not similar at Keynes’ time. At Keynes’ time public expenditure ratios were around 20-25% of GDP, today, they account for 44% of GDP in OECD countries and 56% in France, every increase in public expenditure from this level will not have any effect on real economic growth, the trick has been used too long, too much.

Often, the Keynesians forget to mention public debt (Keynesians are not interested in stocks), but public debt is the sum of past deficit. At Keynes’ time there was room for manoeuvre to play with deficit, today no. You give the feeling that the Chancellor can increase (or reduce) deficit at will (fine tuning policy), (it is easier to increase than to decrease it). It seems that the starting point is not do we increase deficit or not, but what is the stock of our public debt? There is a point that is overlooked by Keynesians, the link between a fiscal deficit (a flow) with the debt (a stock). As far as I know, a deficit is an increase in debt. The next question is: is the debt sustainable? Debt sustainability varies according to each country’s level of income, and capacity to borrow on the domestic and international market. In my view, a gross public debt ratio of more than 80% of GDP for a developed country is not sustainable. The cause of the increase in debt, such as subsidy to financial institutions from 2007, or other factors (fiscal stabiliser), or a permanent fiscal deficit policy, is here irrelevant. The question is whether we can today service this debt burden. The problem is that every body has a bad fiscal situation, but some more than others. Japan public debt (199% of GDP) (gross public debt ratio end 2010), Italy (132%), Greece (129%), Belgium (104%), Portugal (95%), France (94%), USA (90%), Ireland (83%), UK (82%) and Germany (81%) (All these debt ratios are underestimated because civil servant pension is not included) (Estimation end 2010, source: OECD Economic Outlook 87 database).

When asked who will pay, the Keynesians reply, nobody, the government has the magic power to refinance perpetually its debt and in addition it will finance new infrastructure, this is really fantastic, not only you borrow to finance your growing debt and you can borrow to finance new infrastructure. How do you say that in English? To have his cake and to eat it? But I assume that there is a need to mobilize the necessary cash to service the debt every year. This liquidity ratio (gross financing needs) in 2010 accounts for a swooping 64% of GDP for Japan, (for one year), 32% of GDP for the US, 25% of GDP for France, Belgium, Italy, and 20% for UK, (source IMF/FAD, Navigating the Fiscal Challenges, May 2010). These are not small numbers and the markets are right to show some nervousness about the ability of these countries to service their debt. In addition countries should borrow more for another stimulus? But there is a limit even for governments, the limit is the capacity to reimburse, now if you consider that a government can print money as you mention, we can always ask advice to Zimbabwe leader (another Keynesian?).

Not only we question the Keynesian stimulus today on practical ground (the unsustainable level of the existing debt and debt service) but we question the “obvious” idea that a fiscal deficit has always a dynamic effect on economic growth. We think that this is not necessarily true, particularly during our time (it was true at Keynes time), so in my mind, Keynes was right, Keynesians are sometimes wrong. Let’s go to the other side of the coin, the public debt is not only the sum of past deficits, it is also the present value of future taxes. There is no other way to finance a public debt than the recourse to: a) the inflation tax, b) default or c) a permanent tax increase (this is where Ricardo is so modern). The tax burden is already too high (in particular in European countries (which is the cause of eurosclerosis) (the ratio of general government revenue is above 50% of GDP in Norway & Denmark (55% of GDP in 2010), Sweden (53%), above 45% in Belgium (50%), France (48%), and Italy (47%). In UK it is “only” 41% and 31% in US (all data from OECD). These levels of tax were not seen at Keynes time. So why consider implicitly that our time is similar to Keynes’? The apparent scientificity of econometric models does not add any scientific evidence to the fact that we compare two different worlds (logical mistake). The tax ratio is going to increase, in particular in the US and in Europe from already a high level, and this will affect negatively economic growth. Will private enterprises continue to invest, hire people with a tax burden above 45% of GDP? In “rich” countries, the potential GDP is going to decline, not because of lack of fiscal deficit, but because of increasing tax burden due to non-sustainable public finance.

Given the present stock of debt, fiscal deficit will increase the debt ratio, which reduces economic growth, the exact opposite of the Keynesian dogma. The standard linear Keynesian economic model, which assumes a multiplier >1 is not working anymore in countries with high public debt ratios (above 70-75% of GDP). According to IMF/FAD (Navigating the Fiscal Challenges (2010), “the accumulated public debt, even if does not result in overt debt crises, becomes a burden that slows long-term potential growth”. If IMF/FAD, Rogoff & Reinhart are right, therefore, I assume that the fiscal stimulus policy is rather weak. Who is right, who is wrong in front of two opposite conclusions?

The conclusion might be: a) let’s the fiscal stabilizers run their stance; b) the countries with the highest public debt should stabilize their debt burden (even US) to 60% of GDP in 2030(?); they have to do it, in an orderly way. Further fiscal activism will be followed by a long-term slow down; tightening might be associated with a lower growth (during a certain period of time), you think you have choice between deficit or recession; you will have deficit and recession.

j-p Dumas, independent consultant

26/07/2010

Source: http://jpdumas007.blogspot.com/2010/08/you-think-you-have-choice-between.html