The world-wide quest for balanced budgets among finance ministers

ON the rise of the s-word
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The Independent Online
STABILITY. This is the new buzz-word of finance ministers. We had a dose of the UK version last week from our own Gordon Brown. At the weekend we had the European version from Theo Waigel, the German Finance Minister, suggesting that the economic and monetary union (EMU) stability pact should be brought forward.

Yesterday this was endorsed by Yves-Thibault de Silguy, the European commissioner for economic and monetary affairs. And tomorrow we will get a feeling for how the European Union (EU) proposes to cope with the potentially destabilising effect of the high-debt EMU members - countries that do not formally comply with the entry criteria, but which will become founder members of EMU none the less.

This drive for stability raises two questions. The first is why? Why has it suddenly become the dominant force not just in European politics, but in most mature democracies? After all, one of the reasons why President Clinton is so popular is that he appears to be delivering a balanced budget.

As far as European countries are concerned there is, of course, the immediate pressure from EMU, which is forcing the countries with a record of instability to try to lift their game. But the quest for stability carries a price in higher taxes, and this does not explain the ease with which these countries have sold this burden to their electorates. Nor does it explain why the Chancellor here puts this to the top of his wish-list - or the favourable response in the US to the prospect of the balanced budget.

I think the answer lies in a changed set of preferences by voters, to which politicians feel they must respond. Go back five years and fiscal virtue was something which politicians felt that had formally to favour, but in practice they were prepared to allow deficits to flourish. Now they seem to be acting - despite the short-term pain - in the same way as they talk.

If this line of argument is right, we could be in for a prolonged period of fiscal stability, a period when the normal practice is not just for budgets to be balanced, but for the long-term trend of public sector debt as a proportion of GDP to come down world-wide. This would lead to the second question: what effect will a long period of fiscal stability have on the world economy and the climate for investment?

The starting point of this answer is whether the s-word, stability, will lead to the d-word, deflation. The case that the world of investment has utterly changed was well made earlier this month is a paper from the Global Investment Strategist, one of the publications of the Bank Credit Analyst group in Montreal. It argues that yesterday's rules, the rules for an inflationary world, no longer apply. For the last 18 years all you had to do was to buy equities when there was the prospect of a fall in interest rates.

Now, the authors argue, the rules are changing. If you look at the relationship between equity and bond returns over the last 40 years, periods of low inflation cause the correlation to become negative. So at some point falling interest rates could become a negative for equity investment: it would be a sign of worsening deflation, rather than a trigger for a new equity boom.

The time to worry about bonds, on the other hand, is when growth surges. To see this point, have a look at the graph, which charts US bond yields and G7 growth since 1980. There have been a number of points, marked by the arrows, when growth has fallen off sharply (bottom graph). In each case this seems to precede or coincide with a fall in bond yields, also marked by the little arrows. The authors have taken G7 growth (rather than just US) and US bond yields (rather than some weighted G7 bond yield, but the similarity is striking none the less. The conclusion is that since global growth is slowing this is not a time to worry about rising bond yields.

This paper notes three other investment themes. One is global bond convergence - as global deflation takes hold, the chances are that all bonds in the main currencies will move towards each other, perhaps to a 4 to 5 per cent range. The moral here would be to sell very low-yielding ones (like the Japanese) and buy US and UK bonds. European bonds should be held.

The second theme is that the Japanese authorities panic when the Nikkei index goes below about 16000. Each time that has happened there has been a determined effort to stimulate the economy. So far, the four packages in the last five months have failed to achieve much. But expect a more determined one shortly, maybe including some relaxation in the sales tax, the tightening of which last spring helped push the economy back into recession.

The third theme is that the equity cult in the US will not continue for ever. "In the short term," the authors acknowledge, "it could keep going and may even sprout into a full-fledged mania. In the bigger picture, however, the deflation in goods prices will put downward pressure on profit growth. The market is getting set for a boom-bust cycle."

Well, that is just one view and an evidently unfashionable one at the moment, given what share prices have been doing around the world. I suppose the explanation for that is that we are seeing the pluses from global deflation - in particular near zero inflation - without yet catching any sight, except in East Asia, of the minuses. You do not need to argue that the imbalances in North America and Europe are anything like as great as those in East Asia - they are not - to accept that the deflationary impact on the world economy from the reversal of fortune of its fastest- growing area will have considerable deflationary impact on the West.

Indeed, it is interesting that our quest for stability should be coming at exactly the same time that East Asia has hit the buffers. On the one hand this makes it easier for Europe and North America to reach the goal of low inflation. But it also gives a further twist to the tightening of policy taking place here.

To be clear: stability is a desirable element of economic policy, and we have not had enough of it. So in that sense everything that Gordon Brown and his fellow finance ministers are saying is valid. But the drive for European stability is being framed in a vacuum: 18 months from now the pace of the world economy will have changed again, and on balance the probability is that G7 growth will be heading downwards.