The Spend-And-Borrow EconomyWhat's the exit strategy from the monetary and fiscal easing?
By Nouriel Roubini
Go To Original
In the last few months the world economy has been saved from a near-depression. That feat has been achieved by a range of extraordinary government stimulus measures: In the U.S. and in China, and to a lesser extent in Europe, Japan and other countries, governments have pumped liquidity, slashed policy rates, cut taxes, primed demand and ring-fenced and back-stopped the financial system. All of this has worked, but at a cost. Governments have been spending and borrowing like never before. The question now is: how do they stop?
This is not a simple problem. Restore normality too soon and the risk is that a weak recovery will double dip into a second and deeper recession. Restore it too late and inflation will already be ingrained.
Consider how much has been committed and how much has been spent. In the U.S. alone, when you add up the government's liquidity support measures, its re-capitalizations of banks, its guarantees of bad assets, its extension of deposit insurance and guarantees of unsecured bank debt, at least $12 trillion has been committed, and a quarter of that has already been spent. Along with the rise in spending there has also been a very large fiscal stimulus, pushing the federal budget deficit to 13% of gross domestic product this year. (Next year, on current plans, the deficit will fall back but still amount to 10% of GDP.)
Not all the measures adopted appear on the budgetary bottom line. As well as monetary easing and fiscal stimulus, the U.S. and other governments have resorted to unconventional measures to ease monetary conditions. In the U.S., Japan and the U.K., real interest rates have been pushed down to zero, and governments have resorted to buying long-dated securities, the goal of which--only partially achieved--was to hold down long-term interest rates.
The Fed, for example, has committed to spending $1.8 trillion on longer-dated Treasury bonds and other securities, but most of this spending is money the government has printed itself, simply by creating central bank monetary base. It doesn't add to the budget deficit, although it does add to the long-term risk profile of the government doing the spending as monetization of fiscal deficit can eventually be inflationary.
This massive escalation of central government spending and borrowing was necessary. For most of last year, governments lagged well behind the curve of the unfolding crisis. For too long policymakers continued to believe that the house-price bubble was an isolated aberration that would self-correct without impacting the wider economy, and that the unprecedented growth in household indebtedness was not a matter of concern. By the final quarter of last year, however, the global economy was in freefall, with industrial production, private demand, employment and broad GDP all contracting at a rate indicating something close to depression at hand. Policymakers suddenly went into corrective overdrive in late 2008--not a moment too soon.
The second-quarter GDP estimates for the U.S. show just how significant this aggressive front-loaded policy stimulus has been. While total GDP growth was sharply negative in the first quarter--around -5.6%--the rate of decline in the second quarter had moderated to around -1.5%. Credit this relative improvement to governmental monetary, fiscal and financial stimulus. The private components of GDP, private demand and capital expenditure, were actually still very weak. But government spending rose by 5.6%, breaking what otherwise would have been another quarter of headlong GDP contraction.
Necessary as the stimulus has been, it cannot go on indefinitely. Governments cannot run deficits of 10% or more of GDP, and they cannot go on doubling the monetary base, without eventually stoking inflation expectations, pushing up long-term interest rates and eventually eroding their very viability as sovereign borrowers. Not even the U.S. can do that.
The fiscal implications of the current policy package are particularly serious. For the time being, fiscal policy has been put at the service of survival, but the current price of survival is that net public debt is going to double as a share of GDP between 2008 and 2014. Even using the very optimistic forecasts of the Congressional Budget Office, which anticipate growth of around 4% over the next few years, the net debt burden will rise from 40% of GDP to 80%--that's an increase in the debt stock of about $9 trillion. The interest charge alone on that increased debt will be in the region of $300 billion to $400 billion a year, which in turn may mean more borrowing to pay the interest if primary deficits are not reduced. When governments reach the point where they are borrowing to pay the interest on their borrowing they are coming dangerously close to running a sovereign Ponzi scheme.
Ponzi schemes have a way of ending unhappily. To get out of the Ponzi trap, governments will have to raise taxes, or cut spending, or monetize the debt--or most likely do some combination of all three.
Monetization is already happening. This is where a government effectively prints money by allowing the central bank to create base money that is used to buy government debt, thereby increasing liquidity and holding down long-term interest rates (because the additional demand for these securities pushes up bond prices, thereby lowering the real interest rate the securities pay, as well as putting money into the pockets of the investors who have sold the securities).
Over time, monetization is inflationary, but the inflationary effect is insidious because it is not immediately visible. In the short run deflation will outplay inflation. In most developed countries today there is so much slack in economies, with weak demand and high unemployment, that prices cannot rise. The velocity of money is also weak, as financial institutions are receiving liquidity from central banks and hoarding it to rebuild their balance sheets, instead of lending it out. But as the economy recovers, these effects will abate, and the growth of the monetary base caused by monetization will eventually drive expected and actual inflation. And once markets start to anticipate that scenario, it may already be too late to avert an inflationary surge.
Simply issuing debt in the form of Treasury bonds offers no escape. The more debt a government issues, the higher the risk it will eventually face refinancing problems and/or default on that debt. Accordingly, investors will demand a higher return for investing in that debt, and that in turn will push up rates. Independent rating agencies have already downgraded the sovereign risk rating of countries like Greece and Ireland, and it cannot be ruled out that core economies of the OECD, including the U.S., could eventually be downgraded.
As it happens, there is little sign today of investors demanding a significantly higher risk premium on U.S. government debt. That is partly because private savings are increasing: Those savings have to be invested somewhere and investors are cautious about alternative investments. Foreign demand for U.S. bonds also remains robust so far. But this demand is unlikely to survive another big round of government-financed stimulus and bailout spending. And unfortunately, such a spending round is rather likely.
Consider that by the end of 2010 most of the tax cuts legislated by the Bush administration in 2001 and 2003 are due to expire. This means that there will be a sharp tax hike, including income taxes, capital gains taxes and taxes on dividends and estates. This hike--equivalent to around 1.5% to 2% of GDP--is already factored in to future calculations of government indebtedness. So if by next year the recovery proves as anemic as I expect, and if unemployment is around 10.5%-11%, as I also expect, then the pressure for another stimulus round early in 2010 will be strong.
A rough calculation goes like this: Stimulus money to keep the lid on rising unemployment is likely to be around $200 billion. Add to that the likely temporary partial extension of the Bush tax cuts and funding of the current administration's plans for universal health care (an additional bill of around $1.5 trillion over 10 years) and you get deficits close to12% of GDP.
This amounts to a fiscal train wreck. For the U.S., it means deficits could remain over 10% of GDP for years. Bond issuance will remain enormous, and it will mean that the Fed will almost certainly have to monetize a proportion of the debt by buying even more government or government-backed securities.
A combination of higher official indebtedness and monetization has the potential to yield the worst of all worlds, pushing up long-term rates and generating increased inflation expectations before a convincing return to growth takes hold. An early return to higher long-term rates will crowd out private demand, as lending rates on mortgages and personal and corporate loans rise too. It is unlikely that actual inflation will emerge this year or even next, but inflation expectations as reflected in long-term interest rates could well be rising later in 2010. This would represent a serious threat to economic recovery, which is predicated on the idea that the actual borrowing rates that individuals and businesses pay will remain low for an extended period.
Yet the alternative--the early withdrawal of the stimulus drug that governments have been dispensing so freely--is even more serious. The present administration believes that deflation is a worse threat than inflation. They are right to think that. Trying to rebuild public finances at a deflationary moment--a time when unemployment is rising, and private demand is still contracting--could be catastrophic, turning recovery into renewed recession.
History offers more than one example of this error. It happened in Japan in the late 1990s when the Japanese government feared the effects of fiscal deficits and of an increase in inflation as the economy was beginning to recover after almost a decade of deflation. Consumption taxes were raised too soon and the "zero interest rate policy" was abandoned. Within a year the economy was back in recession.
It also happened in the U.S. in the 1930s. President Roosevelt instituted a massive stimulus package when he came to office in 1933, to push the U.S. economy out of the depression, but by 1937 the administration was worrying that inflation was returning and that deficits were too large; so it cut spending and raised rates and the Fed tightened monetary policy. By 1938 the economy was heading back into near-depression.
So policymakers are between a rock and a hard place. Stop spending now and risk renewed recession and deeper deflation (stag-deflation). Keep spending now and risk renewed recession amid rising inflation expectations (stagflation).
Yet there is a space between the rock and the hard place. It is not a big space, but it is there.
Governments will have to manage perceptions. Today investors remain willing to bankroll federal spending without any clear or firm indication of how the fiscal crisis--and it is a crisis of extraordinary proportions--is going to be dealt with. That won't last. Clear indications will soon be needed as to how and when public finances will be repaired. That doesn't have to be accomplished soon--but it does have to be communicated soon.
Monetary policy can most likely remain looser for longer (in the developed economies at least)--as long as there is a clear commitment to fiscal consolidation. But a credible fiscal commitment to medium-term fiscal sustainability is vital, because that is what will open up the very narrow window that is the exit route from our current and unsustainable spend-and-borrow economy.