Ditch the delusion that stimulus saved us from GFC

• Warwick McKibbin
• From: The Australian
• August 10, 2011 12:00AM

THE sell-off in global sharemarkets reflects the realisation that debt problems in advanced economies are serious, but it reflects more than this. For some time the fiscal fragility in the global economy has looked like a slow-motion train wreck.

The dynamics of debt sustainability are well understood. For a given initial debt to gross domestic product ratio, an interest rate more than the GDP growth rate combined with a budget deficit implies an explosion of future debt. The higher the initial stock of debt, the more sensitive are debt dynamics to a widening of the gap between interest rates and growth.

Many countries in the Organisation for Economic Co-operation and Development have gross debt to GDP ratios of more than 100 per cent. With continued budget deficits in these economies and rising risk-adjusted interest rates, well above actual growth rates mean a crisis or substantial fiscal consolidation is unavoidable. No amount of wishful thinking can avoid this.

Debt sustainability is one of the problems in southern Europe. Debt is too high and growth has stalled. But the problems in countries such as Greece and Ireland are not just that these countries cannot hope to service their debts.

They are also locked into the eurozone, which means their decade of decline in productivity growth relative to the core country of Germany has meant a competitiveness gap of least 30 per cent. Given existing economic conditions, these countries desperately need a debt rescheduling or default plus a real exchange rate depreciation to restore competitiveness and growth.

Yet due to being within the eurozone, the depreciation cannot come through the nominal exchange rate while Germany remains strong. The only option is a price deflation of 30 per cent. Surprisingly, some countries have started the process of trying to achieve this by imposing tough austerity measures. Undertaking a fiscal contraction in a fixed exchange rate system seems impossible economically or socially. The politics cannot sustain this within these economies.

Another question is whether German taxpayers are willing to bail out the governments of southern Europe. When the problem was just Greece and Ireland this was conceivable; indeed, it should have been done initially. Now that the fiscal unsustainability club has some new applicants, including Italy and Spain, the problem has morphed into a dual problem of too big to fail and too big to bail.

Even with a huge fiscal bailout the impediment to a recovery in Europe is the euro. Either there will be a disorderly exit by countries from the eurozone or policy-makers in Europe could contemplate a sensible response. The euro could be divided into a two-tier system. A premier league with Germany, France and other northern European countries and a first division with the crisis economies trading a different euro (a PIGLET?) at a 35 per cent discount would be a good start.

In the US the problems are different. The US economy has massively misallocated capital for more than a decade due to a variety of regulatory, financial and political distortions. Dealing with this requires substantial balance sheet adjustments including significant deleveraging in parts of the economy.

Wealth had been destroyed and a long period of adjustment was inevitable. Instead the government treated this as a cyclical downturn that could be fixed with a hefty fiscal stimulus and zero interest rates. This response failed to do much except transfer the need to deleverage from the household and banking system into the federal government and the Federal Reserve.

The S&P downgrade is not the problem. Excessive government debt and a lack of understanding of the issues and the solutions by policy-makers and politicians are the problem. The US should follow International Monetary Fund advice and announce a credible future fiscal consolidation of up to 10 per cent of GDP by 2020.

 Cuts beginning next year would start the growth recovery this year, but during 2012 to 2014 our modelling suggests growth will be weak before a substantial recovery after that. The announcement of an inflation target of 5 per cent by the Fed would help as well.

Australia is now likely to be hit with a second global shock. This is different from the GFC in a critical respect. It is a concern over excessive government debt so the response in Australia should not entail a new fiscal package. Indeed with few other countries able to respond with fiscal expansion, it is unlikely that extra government spending would stimulate the Australian economy at all.

The evidence is strong that in a small open economy, fiscal policy in isolation of co-ordinated global action is not effective. Together with a likely perception of increasing fiscal risk from further debt expansion the policy may even be counterproductivenow.

A fiscal contraction or even sticking to a fiscal surplus target in 2013 when revenues fall would impart a larger negative shock into the economy. Better to allow fiscal stabilisers to adjust -- that is, revenues to fall and expenditures to rise -- to buffer the shock with a clear policy of debt stabilisation across future years as increased deficits are brought back into surplus but not by an arbitrary date.

Bad fiscal design always has an unexpected cost. Why is a flood tax being introduced just as the economy slows? The forecast that this would help dampen the boom is now likely to be wrong. There clearly should be an urgent review of the mismatch between spending commitments in the pipeline and highly uncertain revenue. This is essential to better understand future fiscal vulnerability.

The delusion that what saved the Australian economy from the GFC was entirely fiscal policy needs to be jettisoned. Yes, it helped, but many other factors were far more important, such as a flexible exchange rate, independent monetary policy, a strong regulatory system and well-capitalised banks. These are the factors needed to do the heavy lifting this time and should be given due credit for last time.

Warwick McKibbin is director of Australian National University's research school of economics, and a senior fellow at the Brookings Institution, Washington, DC.