Hamish McRae: This is no way for the West to carry on

Economic Studies

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In the world of finance August is not the wicked month; it is July. Or at least that is the usual pattern, for financial crises tend to happen in the run-up to the holiday season rather than during August itself. Why? Well, the not-totally-unfounded reason is that traders in the money markets want to get their books straight before they head off on hols. So they make sure they have no open positions – and that has the effect of bringing any incipient market pressures to the surface. The eurozone crisis this summer has been a case in point.

Politicians don't want to hang around in August either, as we have just seen in the US. Do you believe the US government suddenly ran out of money yesterday? Of course not; it could have scrambled on for another fortnight or more. The deadline was in reality set by politics, not economics.

But by any rational standards the political process by which both the US budget deal and the Greek bailout have been reached are profoundly unsatisfactory. The sight of US legislators clapping each other as though they had done something wonderful is really rather rum. The balance of probability is still that the US will lose its AAA debt rating as this deal does not solve the country's medium-term fiscal problems. As for Europe, Greece may have been bailed out but the way it was done highlighted the plight of the other weaker eurozone members. Yesterday the interest rate on Italian ten-year government debt rose to 6.25 per cent, the highest since the euro was created and one that compares with 2.69 per cent for the US and 2.77 per cent for the UK.

Nor, let's be clear, have we anything to congratulate ourselves here. We may have pulled ourselves back from the brink, but no government in a sophisticated western economy should inherit a fiscal deficit of 10 per cent of GDP or have to carry through the sort of cutbacks that the Coalition faces. This is not reasonable. It is not to get at the previous government to say that we too experienced a failure in the decision-making process of our democracy.

So now it is holiday time. The captains and the kings depart. It is a moment to ponder quite what went wrong with fiscal policy just about everywhere and what is to be done about it. For I think in the months ahead, as the tumult of the markets resume and the world economy quite probably experiences some sort of pause in the recovery, there will be an increasing realisation that the West can't go on like this.

Of course our failure enables the Bric nations to sneer at us. Prime Minister Putin told a party youth camp this week: "They are living beyond their means and shifting a part of the weight of their problems to the world... They are living like parasites off the global economy and their monopoly of the dollar," he said.

We don't need to take any lessons from the Russians about fiscal management. In July 1998 (it had to be July) the IMF and World Bank lent Russia some $33bn in an effort to rescue the country's finances but the rescue failed and Russia devalued the rouble, defaulted on its domestic debt and declared a moratorium for foreign creditors. Unsurprisingly the rouble has not subsequently presented much of a challenge to the dollar as a haven for global savings.

Nor indeed has the renminbi. The Chinese authorities have been deeply critical of US policy but while they continue to resist allowing their currency to be fully convertible its global role is inevitably stunted. While they continue to hold their currency below its equilibrium level by pegging to the dollar, they will inevitably find themselves accumulating dollar assets, thereby actually enhancing the dollar's global role.

Still, the events of the past weeks will have undermined the dollar's position, just as the events in Europe have undermined that of the euro. Our own plight is nothing to be proud about. As this reality sinks in and as, in addition, the fiscal cutbacks everywhere take hold, we – and by this I mean the West in general – will have to confront our failure.

Some quite profound thinking will have to go on. I don't believe there will suddenly be agreement on a single developed world fiscal model; more likely we face a decade of experiment before established good practice gradually emerges. But one thing is for sure: we really can't go on like this.

An inspiring passage from India

As an antidote to the current widespread perception that fiscal probity inevitably leads to economic austerity I have just been rereading the famous 1991 budget speech of Manmohan Singh, then the new finance minister of India. It was 24 July, so just over 20 years ago. He was faced with a budget deficit of 8.5 per cent of GDP, a huge current account deficit and barely enough foreign exchange reserves to cover two weeks' imports. He combined a correction of the fiscal deficit, including higher taxes and cuts in spending, with the sweeping away of many of the regulations that had been hampering Indian business. It worked. He finished with this ringing paragraph.

"I do not minimise the difficulties that lie ahead on the long and arduous journey on which we have embarked. But as Victor Hugo once said: 'No power on earth can stop an idea whose time has come'. I suggest to this august house that the emergence of India as a major economic power in the world happens to be one such idea. Let the whole world hear it loud and clear. India is now wide awake. We shall prevail. We shall overcome."


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