One of the most well-known lines in John Maynard Keynes’ General Theory notes how politicians think of themselves as reacting to “events” when they are in fact “usually the slaves of some defunct economist.” The latest G-20 meeting, held last month in Toronto, proves Keynes’ wisdom once again -- with a twist. The G-20 meeting ended with a collective endorsement of “growth-friendly fiscal consolidation,” which assumes that if G-20 member states tighten their fiscal belts, states will have to borrow less, pay less interest, and, therefore, will not “crowd-out” private-sector growth. Such a strategy may sound sensible, but it relies on the same fallacy of composition that brought on the banking crisis -- that by making individual banks safe, you make the system as a whole safe -- only in reverse. That is, although it may make sense for any single state (or firm or household) to clean its balance sheet, if all the G-20 states embark on such a course at once, the results could be disastrous. The whole -- Keynes’ critical insight -- is not equivalent to the sum of its parts. The finance ministers of the G-20 states seem to believe that by retrenching in the middle of a recession, they will somehow improve their states’ balance sheets and thus return to a period of economic growth. Deflation, in other words, is now good for growth. How did we get here?
Less than two years ago, the world’s financial institutions pleaded for a taxpayer-funded bailout of the global financial system, arguing that allowing the largest banks and most globalized firms to fail would lead to a prolonged depression. They got what they wanted: according to the IMF, the 34 states that it classifies as “advanced economies” spent approximately 55 percent of their respective GDPs on capital injections, liability guarantees, and outright purchases of bad assets from the major banks.
Although these dramatic measures may have been distasteful to some, they seem to have worked. The global economy avoided a second Great Depression. Between March 2009, when markets began to rebound, and the present day, average global asset prices have rebounded and the appetite of institutional investors for economic risk has steadily grown.
But even the most Herculean efforts of finance ministers and central bankers could not prevent the financial-market contagion from spilling over into the real economy. Credit tightened, investment fell, and unemployment rose across the world. Here, too, policymakers had a response. Nearly every advanced industrialized country in the world embarked on a policy of Keynesian stimulus to buoy their national economies against prolonged recession and deflation. As Robert Skidelsky, the British economic historian, has put it, “the Master” has returned, pushing aside many of the fiscally conservative tenets of the Washington consensus, which drove IMF and World Bank policy on economic crises for decades.
There was a cost to this Keynesian victory, however. Government finances suffered, with fiscal deficits soaring across Europe and North America. As Carmen Reinhart and Kenneth Rogoff recently found, this should not have come as a surprise, since banking crises are almost always followed by sovereign debt crises, or at least prolonged periods of fiscal stress and lost output. When the private-sector firms clean up their balance sheets by reducing debt and stockpiling cash, the public sector takes on debt, partly through automatic stabilizers such as unemployment benefits and partly through discretionary spending, including fiscal-stimulus projects. Now, with the real economy suffering, the taxpayer is saving and reducing debt rather than spending, resulting in increasing deficits and fiscal stress on the public side of the ledger.
The global financial crisis has thus taken an ironic turn. The same large multinational financial firms that sought government bailouts are now shocked and surprised by the spending of “profligate” governments. Indeed, these actors are now speculating against the very governments who brought them back to life by shorting their debt. As a consequence, governments across Europe are adopting austerity measures to outflank the positions of these speculators.
Academic commentators such as N. Gregory Mankiw and Jeffrey Sachs are championing these moves, and both have called for the G-20 to focus on balancing budgets and on “pro-growth” austerity. They point to persistently high unemployment and stagnant output as proof of the failure of current policies. Similarly, former Federal Reserve Chair Alan Greenspan recently declared that the lack of a rise in the cost of servicing long-term U.S. debt is “regrettable,” since “it is fostering a sense of complacency that can have dire consequences.” But does the blame for persistent unemployment and bloated government finances indeed lie with politicians who fell for Keynesian proscriptions? And, more fundamentally, are austerity policies the right course for the G-20 states?
First, in order to say that the global stimulus policy has failed, it is necessary to consider the counterfactual of no fiscal stimulus at all. There is already a natural experiment of this case: the countries of Eastern Europe that decided not to inject large amounts of liquidity into their national economies. For example, in May 2009, as the United States and Western European countries were consciously expanding public deficits, Latvian President Valdis Zatlers set his government on course for “severe budget stabilization measures” and several “structural reforms,” many of which resemble what the G20 is wishing upon itself today. Yet Latvian GDP fell more than 17 percent in the fourth quarter of 2009, while unemployment grew to more than 16 percent, and government finances -- the theoretical beneficiary of all this belt-tightening -- collapsed because of falling tax revenue. These results were replicated from Estonia to Romania with even worse results, suggesting that the G-20 member states should perhaps be careful what they wish for.
Second, financial markets are social phenomena, which means that economic performance is as much determined by market participants’ beliefs as it is by fundamental indicators or textbook policy. In the parlance of technical traders, prices can move on “momentum,” whereby disequilibrating price movements compound one other, further driving market prices away from their true worth -- a dynamic that is visible in sovereign debt markets today.
Imagine, for example, a case in which a number of creditors believe that a certain state is likely to become insolvent in the next few months. The state’s creditors would demand more collateral, or yield, for holding the debt, thereby worsening the cash position of the state. Eventually, the pressure from speculators would cause the state to run out of cash, thereby creating the very situation that investors feared -- but from which they would also profit through the short selling of bonds. Such a scenario feels eerily like 1991, when George Soros famously made $1 billion in profit by short selling the British pound. And just like in 1991, central banks are following the wrong lesson: rather than calling speculators on their positions, European governments appear to have caved to the pressure and favor austerity over demand management.
It is likely that France, Germany, and the United Kingdom will move to cut their deficits dramatically, which will lead to a rise in eurozone unemployment, a decrease in the purchase of U.S. exports, and a faltering of global economic recovery. Falling economic growth in the G-20 states will further lower consumption and increase unemployment. Meanwhile, the financial sector will see its equity holdings shrink and its balance sheets worsen once again. Such a scenario makes it quite possible that these same financial institutions will argue that the stimulus was not big enough and should be tried again -- but now from a more leveraged position. To see a glimpse of such a future, look at Japan: seesawing between spending and retrenchment cost Japan 15 years of growth and employment between 1990 and 2005, when Japan’s economic policymakers were swayed by exactly the same sort of arguments that are ascendant in the G-20 today.