Tuesday, June 15, 2010

Fiscal time bomb yet to explode

PAUL Krugman has a Nobel Prize in economics, and we don't. He is also a columnist with The New York Times, where he writes with insight, deep knowledge, and the courage of his convictions. But he's not infallible. Martin Wolf is chief economics commentator for London's Financial Times, and the most respected of all our tribe worldwide. His columns are rich in detailed grasp of the facts, and in wisdom to judge what weight to give them. But he too is not infallible.

It is because Krugman and Wolf have earned such respect and trust that their crusades, if misdirected, become very dangerous. In my view, that is happening now.

Both disagree sharply with the change in economic tack by Western policymakers in the wake of the Greek fiscal crisis, the subsequent panic in financial markets, and the Tories' victory in the British election.

Last year's consensus was that governments and central banks should remain focused on fighting the legacy of the global recession, and be wary of withdrawing their fiscal and monetary stimulus too soon.

But this year the world has focused on the flipside of that stimulus: debt.

And the more policymakers have focused on debt, the more alarmed they have become: not only by the debt run up to end the recession, but the accumulated debt that has financed three decades of deficits in the G7 economies.

In the 1930s, Keynes taught us that, rather than governments aiming to run balanced budgets, they should adopt a counter-cyclical role: borrow and spend in bad times, when private sector demand has collapsed, then save and repay the debt in good times, when the economy needs no support.

But outside Australia, the first of these goals has proved far more popular with governments than the second. The United States has run a budget surplus just once in the past 50 years. Japan, France and Italy have not run a surplus in the past 30 years, while Britain has had just five years of surplus amid 25 years of deficits. This year, the International Monetary Fund forecast in April, G7 deficits would range from 11.4 per cent of GDP in Britain and 11 per cent in the US, to 5 per cent in Canada, Italy and Germany.

Most alarmingly, by 2015, when their economies are forecast to be back to normal, they would still be running deficits of 7.3 per cent of GDP in Japan, 6.5 per cent in the US, and 4 to 5 per cent in Britain, France and Italy.

Is this sustainable? Take a look at the table below, which shows the IMF's projections of net debt in 2015. Since the Reagan era began, the net debt of the US has soared from 25 per cent of GDP to 66 per cent, and on current settings, the IMF projects it will reach 86 per cent by 2015, and 107 per cent (roughly Greek levels) by 2020.

Japan and Italy already have net debts above 100 per cent of GDP, and by 2015 the IMF projects debt ratios of 75 to 85 per cent of GDP for Britain, France and Germany.

(And Australia? See how low our debt will be? There is no debt problem here. Our problem is having a Liberal Party so clueless on economics that it doesn't know what our real problems are.)

Worse, those G7 debts were run up in good years. Yet the real fiscal time bomb is yet to go off. The West is now in a demographic "sweet spot": many people of working age, relatively few children and retirees. But over the next 20 years, the baby boomers will retire, shrinking the number of workers who pay taxes, while doubling the number of retirees governments will have to support in healthcare, pensions and aged care.

During the Greek crisis, I recalled one of the Reserve Bank's rules of thumb: decide which risk has the most serious consequences if you get it wrong, then lean against it.

The worst risk to the global financial system is not that of investors losing confidence in the Greek government's ability to pay its debts. It is the risk of investors losing confidence in the US government's ability to pay its debts.

Rubbish, Krugman and Wolf interject. The US has deep, sophisticated financial markets. It borrows only in its own currency, and could meet any crisis by raising taxes. Where did the investors fleeing Europe put their money? In US government bonds. It is, Wolf says, "the world's most credible reserve asset".

I humbly disagree. The only sense in which the US is a credible safe haven is that markets now view it as such. But in their modern classic on asset booms and busts, This Time is Different (Princeton), Carmen Reinhart and Kenneth Rogoff show that markets normally view the build-up of dangerous debt overload as safe until the moment the truth dawns, when suddenly everyone wants out.

As long as Washington has a political culture in which one side will veto any tax rise and is indifferent to debt, no one can guarantee that future US governments will honour their commitments. A recent survey of US investors found 46 per cent thought it likely that Uncle Sam would default within a decade; only 33 per cent thought it unlikely.

If this global financial crisis seemed bad, just wait for the one we'll see when investors no longer trust the US government.

That is the risk we must avoid at all costs.


Net debt as a percentage of GDP: 1990, 2015

USA 46%, 86%
Japan 13%, 154%
Germany 29%*, 75%
Britain 27%, 84%
France 25%, 95%
Italy 89%, 122%
Canada 44%, 30%
Australia 6%, 4%**

*1991 ** Treasury estimates, 2015-16