Stephen King: To stimulate or not to stimulate? That is the question

Who is right? The Americans want to see other parts of the world offering more economic stimulus. The Europeans think there's been too much stimulus already.

The arguments on either side are easy enough to spell out. The US believes it has kept the world economy afloat over the last couple of decades. By running an ever-widening balance of payments current account deficit, the US has imported more than it has exported and, hence, has offered a stimulus to the rest of the world.

In the process, however, the US has become over-burdened with debt. The results of this debt addiction include the housing bubble, its subsequent bust, the sub-prime crisis, the credit crunch and the highest level of long-term unemployment in the post-war era. For President Barack Obama and his colleagues at the US Treasury, it's time for someone else to do the heavy lifting to keep the global economy's head above water.

For the Europeans, it's a different story. For them, the crisis stemmed from an earlier period of binge-borrowing, associated with excessively rapid money supply growth, low interest rates, reckless government borrowing and a failure to recognise the massive growth in leverage. They have no desire to follow the American model of old, because they can see the unfortunate results.

The US may not have been the worst-hit country during the financial crisis, but the US was, nevertheless, the epicentre of the crisis. Why should European policymakers emulate a model which has so clearly ended in failure? For them, now is a time for austerity. It's payback time for years of ill-discipline and an opportunity to reassure nervous financial markets that borrowing really is under control.

These contrasting positions partly reflect differing abilities to tap the world's capital markets. The US enjoys the huge benefit of having the world's reserve currency. At times of financial distress, investors typically flock to buy dollars, selling more or less everything else in the process. As a result, it's proved relatively easy for the US to fund what is now an absolutely huge budget deficit. Foreign purchases of Treasuries have risen substantially over the last 18 months, driving 10 year yields down to a paltry 3 per cent. Budget deficits across Europe are mostly a lot lower than America's yet, for many countries, borrowing costs are a lot higher. Spain, for example, has to borrow at a rate of 4.5 per cent, and much of its debt is probably being bought up by the European Central Bank because a nervous market is no longer interested.

But there's a lot more to this difference of view than the ability to tap capital markets. The Germans, for example, are able to borrow at a remarkably low interest rate of only 2.6 per cent, yet Angela Merkel and her colleagues have no wish to follow America's road to perdition, as they see it.

It's partly a matter of history. America's 20th-century economic crisis was the Great Depression, a time of collapsing activity, mass unemployment and deflation. Germany's crisis was its hyperinflation of the 1920s, when people carted money around in wheelbarrows and when cigarettes became an important alternative medium of exchange. The Americans are prepared to take monetary and fiscal gambles to prevent a collapse in activity. The Germans fear that such gambles will simply see the return of excessive inflation. Already, they're worried that the shenanigans taking place elsewhere in Europe are beginning to contaminate German values. Not surprisingly, then, they're ill-disposed to delivering a European economic stimulus in response to American overtures.

There is also, however, a particularly awkward economic question to be resolved, and it goes right to the heart of the debate about the success or otherwise of Keynesian stimulus measures. Keynes thought economies could settle down at levels of activity well below full employment. He also believed that the market, left to its own devices, would not be able to generate any kind of rebound. The result would be deficient demand and persistently high unemployment of the kind seen in the 1930s. Companies wouldn't hire enough workers to reduce unemployment for the simple reason that each company, on its own, would be unable to see the collective increase in demand created by a return to full employment across the economy as a whole. What was needed, instead, was an intervention by policymakers in the form of a monetary or fiscal stimulus that would jolt the economy back on to the full employment path.

That's fine as far as it goes. But how should full employment be defined? Should we be aiming for a return to conditions as they were before the crisis unfolded in 2007 and 2008? Or should we accept that the boom which preceded the bust was, itself, undesirable and that no policymaker with a reasonable grip on reality should be hoping to see its return?

If so, we need to adjust our expectations of what can be achieved by Keynesian policies. The economic world isn't composed of simple binary choices along the lines of full employment versus unemployment or recovery versus recession. If we're coming out of recession, but we don't want a return to the conditions that preceded the recession, we have to accept that, pre-recession, we were probably living beyond our means.

To that extent, Keynesian policies have limitations. They have certainly helped to prevent a Great Depression Mark II. But they cannot take us back to where we were before the crisis because, at some point, we need to get a grip on the excessive debts which led to the crisis in the first place.

The Europeans recognise this constraint more than the Americans. That's hardly surprising. Europe finds itself attacked from all sides: too much debt in the likes of Greece, Portugal and Spain and too little debt in Germany. Europe's fiscal crisis may be partly of its own making but it also reflects growing uncertainty amongst the world's creditors that recovery can only be delivered via ongoing fiscal stimulus. Japan's government debt, after all, has expanded hugely over the years, reflecting persistent budget deficits, yet its economy remains flat on its back.

Keynesian policies may prevent the worst from happening, but they cannot take us back to a world of leverage where creditors are forever dipping into their pockets to provide money for the profligate to spend on all sorts of madcap ventures. Eventually, debtor nations need to adjust their spending habits. The US, the UK and others have been living beyond their means for many years and will probably have to accept that the level of output and its growth rate are now permanently lower than they appeared to be before the crisis began.

The case for austerity rests on accepting this new reality. Austerity is hardly pleasant, but it might just prevent a repeat of the problems which, two years ago, culminated in the worst Western recession since the 1930s. That, in itself, would be some achievement.



Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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