|The Fear of Financial Markets|
The Hankyoreh (South Korea), June 26, 2010
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Governments around the world are now turning towards deficit reduction with an extraordinary vigor, not necessarily because they believe it is necessary, but because they claim that financial markets believe it is necessary. We need governments with more courage.
First, it is important to understand that the obsession with deficit reduction has no basis in economic reality. The economic argument against large budget deficits is that the government is pulling resources away from other more productive areas of the economy. In a context where the deficit is financed with borrowing from the public, this leads to high interest rates. In a context where the deficit is financed through debt issued by the central bank, the result is inflation.
Neither of these stories can be plausibly told in the current economic situation. Interest rates are near historic lows despite the high level of borrowing by governments around the world. The reason is the collapse of private sector demand. Governments around the world are rightly stepping in to pump up demand in the wake of a plunge of private sector demand. Total borrowing is still lower than normal. The public sector borrowing is filling a hole, not pushing demand over the top.
It’s the same story with inflation. Nearly everywhere the greater problem at present and the foreseeable future is the risk of falling prices, not rising prices. There is enormous excess capacity throughout the world economy. There is not a plausible story that inflation can rise out of control anywhere in the foreseeable future.
To put the situation in some perspective, the United States has just lost close to $6 trillion in housing wealth and a somewhat larger amount of stock wealth. There has been a similar loss of wealth in Europe. In this context, how could the creation of $2-$3 trillion of money by central banks lead to inflation?
In short, it is very difficult to find an economic basis for concerns that large budget deficits will create problems in any near-term or mid-term context. Yet, governments across the world are actively pursuing deficit-cutting agendas. The rationale given is that deficit reduction is necessary to assuage the financial markets. The example of Greece is held up as a warning for all to see. The financial markets sent interest rates on Greek debt soaring. Deficit hawks everywhere now warn that other countries will be similarly attacked, unless they take steps now to reduce their deficits.
Greece really does have serious problems with its budget. It used phony accounting to conceal the true size of its debt and deficit. It also has real problems collecting taxes. The Organization for Economic Co-operation and Development estimates the size of its underground economy as one-third of GDP. These factors put Greece in a distinctly worse situation than most other countries.
But even in the case of Greece, the decision to leave the country to the mercies of financial markets was a policy decision, not something driven by the economic fundamentals. The European Union and the European Central Bank had the ability to support Greek debt, as they ultimately opted to do. Given the small size of Greece’s economy relative to the European Union, supporting its debt presents little direct risk, although the issues of moral hazard (countries freeloading on their more fiscally cautious neighbors) are real.