Economics for Dangerous Times
These are dangerous economic times. The Keynesian framework within which the policy response to the Great Recession was forged in 2009 is no longer adequate. The OECD may have reached the limits of crude fiscal stimulus and monetary expansion.
Fiscal credibility has eroded: the financial brink on which Spain and Italy now teeter has seen the borrowing costs of their governments rise to exceed those of the government of Sri Lanka, while unprecedentedly US government debt has lost its triple-A rating. Even where monetary expansion is still feasible, as in the USA and the UK, interest rates are so low that it is hard to see how this would produce much of a stimulus. Yet over recent months the risk of a double-dip recession in the absence of further stimulus has evidently increased. In the UK the incipient recovery of 2010 has stalled – the past nine months have seen virtually zero growth at a time when the economy should have been bouncing back from the deep recession of 2009, and hence growing faster than usual. The UK started from a genuinely difficult policy dilemma. Meanwhile, and less excusably, the USA and the Euro-Zone have each conjured up considerable risks of a return to recession through distinct yet persistent policy dysfunctions.
The Keynesian-Classical debate between fiscal and monetary rectitude and fiscal and monetary expansion thus now presents a choice between two unappealing dangers: crisis and recession. The challenge to economists is not to line up on either side of this stale battleground but to come up with alternatives.
To avert the risk of a return to recession aggregate demand has to be increased. Consumers are overextended and so want to save, but in consequence firms anticipate weak demand and so are reluctant to invest: in the private sector the desire to save is fatally detached from the investment that it could finance. The only economic actor which combines these decisions is government: government can increase its savings and its investment at the same time.
To increase savings fiscal action must improve the balance sheet. This does not imply that the government must reduce its fiscal deficit: the balance sheet is made up of both gross liabilities and gross assets. To improve the balance sheet gross assets must increase by more than gross liabilities. In present circumstances this is relatively easy. Currently public debt costs only around 3 percent. Meanwhile, the desperate conditions prevailing in the construction sector have sharply reduced the cost of building infrastructure. This is an opportunity for society to purchase at bargain prices economically productive investments that it needs anyway. As long as the process of project selection is technically proficient and properly scrutinized, it should be straightforward to devise a portfolio of additional assets that yield a rate of return at least comparable to the modest cost of servicing the debt that finances them.
But financial markets do not even need to be convinced that public investment projects can cover their cost. Indeed, given the current scepticism of government in financial markets, public policy must assume that financial markets would not find such a strategy fiscally credible. Fortunately, it is straightforward to reconcile an increase in public borrowing with a credible improvement in the public balance sheet. For public assets assuredly to increase by more than public liabilities, the increase in public investment and aggregate spending should be combined with a shift in the composition of public spending from recurrent to capital items.
Not only does a package of an increase in aggregate public spending with a shift from recurrent to capital spending make economic sense, it has the potential for political consensus. The political right can seek comfort in reductions in recurrent spending, while the political left can seek comfort in an increase in aggregate public expenditure. Politically, this is analogous to the compromise US Congress package. But unlike that compromise it is not economically illiterate.
Ultimately, fiscal prudence is about the balance sheet: insolvency comes not from the level of gross liabilities but from their mismatch with assets. American political theatre has, in one sense, been helpful: it has given us a new morality tale in the dysfunctional consequences of polarization. We simply cannot afford to dig into the ideological trenches of the need to cut government borrowing versus the need to increase public recurrent expenditure. Both now pose unacceptable risks. There is room for a constructive middle-ground: economists should be building it.
This article first appeared on Social Europe Journal