Stephen King: Public spending may only lead to private saving

Loosening fiscal policy is fine in theory but a lot more difficult to pull off successfully in practice
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What will the world economy look like in one or two years' time? Accurate long-range economic forecasts are difficult to make at the best of times. In our new world of war, fear and uncertainty, the task is even harder. Nevertheless, a new consensus appears to be emerging. Yes, everyone accepts that there will be big short-term losses in terms of economic activity, particularly in the US. However, there is growing optimism that the policy stimulus now being thrown at the global economy will be enough to see a return to decent economic growth next year.

This is not just a case of Micawberism. There are some genuine reasons for optimism. After all, the real Fed funds rate – adjusting the US benchmark interest rate for inflation – has turned negative, typically an encouraging early-warning signal of future economic recovery. And, as far as the Administration and Congress are concerned, Lord Keynes appears to have made a comeback, with moves towards a significant loosening of the fiscal purse strings. At this stage, the numbers are still highly uncertain, but it now looks as though the fiscal injection to the US economy could amount to approaching 2 per cent of GDP next year: enough, perhaps, to ensure that the outcome for economic growth in 2002 will be positive rather than negative.

There is, however, something a bit odd about all this talk of fiscal support. Suddenly, looser fiscal policy is seen to be a good thing. Yet, once upon a time, fiscal loosening was most definitely a bad thing. The US, for example, had been engaged in a 15-year period of deficit reduction. The process started with the Gramm-Rudman act in the mid-1980s and reached its apotheosis towards the end of the Clinton presidency.

Meanwhile, Europe chose to follow its own budgetary hair-shirt policy by sticking fairly rigidly to the objectives laid out within the Maastricht convergence criteria. Even that, however, was not puritanical enough for Europe: the convergence criteria were given extra bite following the adoption of the fiscal Stability Pact.

So can it really be the case that looser fiscal policy is now the answer to all the world's woes when, just a few years ago, it was generally regarded as a sign of economic weakness? Well, obviously, times change. Over the last few years, the private sector was growing very nicely without any requirement for significant public sector support. With the onset of recession, the scales have suddenly shifted: with a sudden loss of private sector aggregate demand, perhaps the public sector will be able to step in to offer a bit of much-needed support.

This argument sounds perfectly reasonable. Yet looser fiscal policy should not be regarded as a "cure-all", a way of removing any potential risks to economic stability. The idea of loosening fiscal policy is fine in theory but is a lot more difficult to pull off successfully in practice. This is not just a question of the lags that operate within the system to delay and obscure the impact of any fiscal loosening. Rather, there are problems associated with assessing the consequences for the broader economy of fiscal loosening, lags or no lags.

Two good historical examples highlight what I'm talking about. The first is the Japanese experience over the last 10 years. The second – perhaps more relevant for today – is the US experience of the late 1960s, when the escalation of the Vietnam War was associated with a combination of loose monetary and fiscal policy.

Japan is an interesting example. In the first half of the 1990s, many economists began to regard Japan's problem as one of debt deflation associated with a Keynesian liquidity trap, which basically meant that monetary policy was fairly impotent. Fiscal loosening seemed ideally suited for this environment. Yet the results have been very poor. The budget deficit has increased in size (in the late 1980s, Japan was recording regular budget surpluses) but has been completely offset by a rise in private-sector savings. Put another way, there was no private sector multiplier associated with the loosening of the fiscal purse strings.

Is this story relevant for America today? Well, there are a lot of differences between Japan and the US. There is, however, one similarity. Japan saw a big decline in asset prices at the beginning of the 1990s that suddenly meant that Japanese consumers and producers were a lot poorer. Their response? Increased savings to ensure that there would be sufficient assets around to support them during their retirements. Their reaction to more government borrowing? A fear of higher future taxes, giving them an additional incentive to save out of current income. Of course, the US has not been through such a calamitous decline in asset prices. Nevertheless, household wealth has taken a dive, providing a strong incentive to raise savings out of current income. This "paradox of thrift" suggests that the multipliers associated with looser fiscal policy might, initially, prove to be rather small.

Which brings me to my second example. The late 1960s were ultimately good years for economic growth. There was a flirtation with recession in 1967 – activity fell marginally in the second quarter – but a true recession did not arrive until the final quarter of 1969. In 1968, the US managed some fairly explosive growth rates; in the first quarter of that year, GDP rose at an annualised quarter-on-quarter rate of 8.4 per cent, more impressive than anything recorded during the "new paradigm" of the late 1990s. In other words, the escalation of American involvement in the Vietnam War – a consequence of which was much looser fiscal policy – proved to be very supportive for US economic growth.

This, however, was a very odd period for the US economy. The profit share collapsed in the late-1960s from earlier highs (see chart). The equity market peaked in nominal terms in the mid-1960s and did not convincingly break through those heights until the early 1980s. All this despite very strong economic growth. What went wrong? There is a relatively straightforward explanation. The combination of loose fiscal and monetary policy kept the labour market tight, leading to relatively high wage increases. These could not be passed on by companies, partly because of the constraints imposed by the Bretton Woods system of fixed exchange rates. As a result, profits came under significant downward pressure. What, therefore, marked a period of considerable economic strength at the same time triggered a period of sustained corporate and financial market weakness – and, eventually, the complete collapse of the Bretton Woods system.

Does this story have relevance for today? The economy is starting from a weaker position this time around and, therefore, labour market constraints and higher real wages may be less of a problem. Nevertheless, it is quite possible to have a recovery that is, ultimately, less profits-rich – and, hence, less market-friendly – than the recoveries seen during the 1980s and 1990s. Moreover, following the Japanese lead, next year's recovery may prove difficult to sustain. After all, America has got plenty of longer term economic imbalances – a large current account deficit, low levels of private sector savings – and a sustained period of economic weakness may now be required. Quick fixes may look attractive but the harsh realities suggest that the US is now in for a prolonged period of economic adjustment.


Stephen King is managing director of economics at HSBC.