Fear Must Not Blind Us to Deflation's Dangers
A consensus is forming that policymakers should tighten fiscal policy, sharply, in countries with large fiscal deficits. Yet what makes these policymakers sure that business and consumers will spend in response to austerity? What if they find that it tips economies into recession, or even deflation?
In last weekend’s communiqué of the Group of 20 leading economies, finance ministers and central bank governors stated that “countries with serious fiscal challenges need to accelerate the pace of consolidation”. Yet the world economy confronts two risks, not one: the first is, indeed, that much of the developed world is going to be Greece; the second is that it will be Japan.
As Adam Posen, outside member of the Bank of England’s monetary policy committee, pointed out in a recent speech, fiscal contraction, along with persistent banking problems and insufficiently loose monetary policy, generated the negative shock in 1997 that entrenched deflation in Japan. Many economic historians argue that the US made a similar mistake in 1937.
How, I wonder, will the world look back on what is now being planned? Germany’s commitment to greater fiscal austerity across the euro zone is powerful, if hardly surprising. Judged by the UK prime minister’s speech on Monday, the UK is on the same path. Happily, the U.S. has not joined the consensus — as yet.
Japan is stuck firmly in deflation. Germany’s most recent rate of annual core inflation was just 0.3 percent. In the U.S., core inflation is 0.9 percent. Another economic shock could shift these economies into deflation, with all the attendant difficulties of trying to make monetary policy bite in a world of post-bubble deleveraging.
Moreover, despite the heroic efforts of central banks, growth of broad monetary aggregates is subdued, mainly because the transmission mechanism is impaired: over the latest 12-month period, U.S. and euro zone M2 grew just 1.6 percent. Monetarists should be quite relaxed about the risks of inflation. They should be concerned, instead, that central banks are failing to give the private sector the liquidity it wants.
Against this background, what would a big tightening of fiscal policy deliver? In the absence of effective monetary policy offsets, one would expect aggregate demand to weaken, possibly sharply. Some economists do believe in “Ricardian equivalence” — the notion that private spending would automatically offset fiscal tightening. But, as Mr Posen argues of Japan, “there is no good evidence ... of strong Ricardian offsets to fiscal policy.” In developed countries today, fiscal deficits are surely a consequence of post-crisis private retrenchment, not the other way round.
This is all very well, many will respond, but what about the risks of a Greek-style meltdown? A year ago, I argued — in response to a vigorous public debate between the Harvard historian, Niall Ferguson, and the Nobel-laureate economist, Paul Krugman — that the rapid rise in U.S. long-term interest rates was no more than a return to normal, after the panic. Subsequent developments strongly support this argument.
U.S. government 10-year bond rates are a mere 3.2 percent, down from 3.9 percent on June 10 2009, Germany’s are 2.6 percent, France’s 3 percent and even the UK’s only 3.4 percent. German rates are now where Japan’s were in early 1997, during the long slide from 7.9 percent in 1990 to just above 1 percent today. What about default risk? Markets seem to view that as close to zero: interest rates on index-linked bonds in the France, Germany, the UK and U.S. are about 1 percent. What, for that matter, does the spread between conventional and index-linked bonds tell us about inflation expectations? We can say that these are, happily, still well anchored, at about 2 percent in the U.S., Germany and France. In the UK, they are somewhat higher.
The question is whether such confidence will last. My guess — there is no certainty here — is that the U.S. is more likely to be able to borrow for a long time, like Japan, than to be shut out of markets, like Greece, with the UK in-between.
As borrowers, the U.S. and UK have advantages: first, their private sector surpluses cover some three-quarters and 90 percent, respectively, of their fiscal deficits; second, many private-sector investors need assets that match liabilities in their domestic currency; third, because these countries have active central banks, bondholders suffer no significant liquidity risk; fourth, they have floating exchange rates, which take some of the strain of changes in confidence; fifth, they have policy autonomy, which gives a reasonable prospect of near-term economic growth; and, finally, the U.S. offers the world’s most credible reserve asset. That gives the U.S. government the position vis-à-vis the world that the Japanese government possesses vis-à-vis Japanese savers.
Critics could argue that these arguments downplay the risks of a “sudden stop” in financial markets. But risks arise on both sides. When Japan — or Canada or Sweden — tightened in the 1990s, a buoyant world economy could absorb excess domestic supply. There is no world economy big enough to offset renewed contraction in Europe and the U.S. Concerted fiscal tightening could, in current circumstances, fail: larger cyclical deficits, as economies weaken, could offset attempts at structural fiscal tightening. For countries in southern Europe, this is already a danger. Much of the world could end up in a beggar-my-neighbor position towards an increasingly fiscally stretched U.S.
The G20 did stress “the need for our countries to put in place credible, growth-friendly measures, to deliver fiscal sustainability, differentiated for and tailored to national circumstances.” That seems fair. In so doing, policymakers must recognize that deflation is a risk, too, and that tighter fiscal policy requires effective monetary policy offsets, which may be hard to deliver today, above all in the euro zone.
Premature fiscal tightening is, warns experience, as big a danger as delayed tightening would be. There are no certainties here. The world economy — or at least that of the advanced countries — remains disturbingly fragile. Only those who believe the economy is a morality play, in which those they deem wicked should suffer punishment, would enjoy that painful result.