It’s been a hell of a week, no? Congress overcame its impasse on the debt ceiling, agreeing to raise it in exchange for a multi-trillion dollar debt reduction package that amounts to nothing more than an incredibly ill-timed austerity plan. Oh, and it hardly puts a dent in our long-term fiscal imbalances, which are almost solely due to rising health care costs. Great job.
The stock market is way down. Not a big surprise there as chances of the world falling back into recession are as high as ever. Nonetheless, everyone is panicking.
Kenneth Rogoff has some complaints regarding the names we’ve designated to our recent troubles, mainly “The Great Recession”:
Why is everyone still referring to the recent financial crisis as the “Great Recession”? The term, after all, is predicated on a dangerous misdiagnosis of the problems that confront the United States and other countries, leading to bad forecasts and bad policy.
The phrase “Great Recession” creates the impression that the economy is following the contours of a typical recession, only more severe – something like a really bad cold. That is why, throughout this downturn, forecasters and analysts who have tried to make analogies to past post-war US recessions have gotten it so wrong. Moreover, too many policymakers have relied on the belief that, at the end of the day, this is just a deep recession that can be subdued by a generous helping of conventional policy tools, whether fiscal policy or massive bailouts.
But the real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation.
This, accompanied with recent news on the widening gap between yields on Italian/Spanish and German bonds, led me to ponder something that had been bugging me over the past year: “The debt crisis” in Europe. Similar to Rogoff’s complaint, I find that this is a mischaracterization. At least, it’s a mischaracterization on the level that it misinformed the type of policy response required to solve it, also mentioned by Rogoff.
Here, we’re in a situation in which we’ve very badly confused cause and effect. The eurozone’s mess began the same as everyone else’s: a massive financial crisis that precipitated a plunge in consumer spending and an extended period of deleveraging, which continues. This sovereign-debt crisis wouldn’t actually be a thing without this antecedent, which has indefinitely suspended the prospect of reasonable future growth. This future growth is what’s needed to keep debt levels, as percentages of GDP, at reasonable levels and keep servicing costs manageable. However, policymakers at the European Central Bank have either conflated these or [insert something much more cynical].
Unfortunately, the cure to this is not really feasible within the context of current eurozone political dynamics.
Italy is one of the hot spots right now, so let’s use it as an example. Italy spends less on government services etc. than it receives in tax revenues, also known as a primary surplus—a pretty healthy situation. However, they still run a budget deficit when debt services (the interest paid on their outstanding debt) are accounted for. The solution to Italy’s problem is simple, and it’s the same as ours: very loose monetary policy and fiscal stimulus. But where Italy and the United States differ is hugely important; the United States is the master of its own monetary policy. Conversely, Italy is not since it doesn’t have its own central bank with the power to create money. It has the ECB, which sets monetary policy for the entire eurozone. Unfortunately for some countries, including Italy, conditions across the eurozone don’t require the same monetary policy. And doubly unfortunate, the ECB has been less than receptive to the needs of Italy and the like. What Italy could really use right about now and in the near future is some inflation! A commitment to prolonged, modest inflation would increase economic activity in the short-term and consequently relieve Italy of its euro-inflicted “debt-problem”. Many smart people agree that this (the correct policy prescription) won’t happen, and as such, Italy will be forced to avoid a massive debt-spiral by drastically cutting spending, which only further depresses growth because it won’t be accompanied with lower interest rates from the ECB. Lose-lose.
The short version of this is that the problems in Europe are the product of a massive financial crisis, as well as poor fiscal integration between eurozone countries and one-size-fits-none monetary policy. They aren’t the product of large quantities of debt, per se.