There were plenty of central bankers and economists with glum faces at Jackson Hole, Wyoming this week as speakers reviewed the challenges ahead. So far the global economy has not responded to various rescue plans, with GDP slowingand national debt rising across a whole slew of economies.
Before we look at the daunting challenges ahead,we should review what has already been achieved. We avoided a global banking collapse, an accompanying deflationary spiral and a depression similar to the 1930s. There have been a few side-effects, but do not underestimate the importance of avoiding a deflationary spiral.
In times of uncertainty, households and corporates save at higher than normal rates. Savings contribute to economic growth when channeled through the financial system into new investment, but in a financial crisis they are applied to pay down debt, causing a savings-investment mismatch. Any amount saved that is not re-invested in the economy, whether it used to pay down debt or buried in a tin at the bottom of the garden, causes a fall in national income.
If 2% of every trillion dollars earned, for example, is used to repay debt, then people who would have supplied 1 trillion dollars worth of goods and services will only receive $980 billion in income. That doesn't seem so bad, but if 2% of the reduced income is similarly applied to repay debt, then income available contracts to $960.4 billion. And keeps contracting each time income is recycled. In extreme cases the above scenario could be replayed many times over before the behavior ends, causing a sharp fall in national income. Repetition of the above cycle twenty times, for example, would reduce available income by a third. That is a deflationary spiral. Something to be avoided at all costs.
The proven antidote to deflation bites is to run a fiscal deficit: government expenditure in excess of revenue help to offset the savings-investment shortfall. Stimulus programs, however, have been badly managed, with no thought as to how the burgeoning national debt would be repaid. Mountains of national debt were incurred to head off the deflationary spiral, but there is very little to show for it. Deficits spent on school halls, public fountains, checks in the mail and tax cuts offer no means of repayment. Investment in infrastructure projects that offer a market-related return on investment -- that can be used to repay the debt over time -- have so far been scarce.
The result of a weak fiscal balance sheet is instability. High unemployment, low consumer spending, restricted consumer credit, and a falling housing market are all consequences of increased uncertainty.
Also, private capital investment remains scarce despite super-low interest rates and cashed up corporate balance sheets. For the same reason that cashed up banks are not lending to small business: uncertainty. Both banks and business face an unpredictable environment, with the possibility of further falls in employment and consumer spending, restricted consumer credit, a falling housing market, unsustainably low interest rates, and the threat of increased taxes. Uncertainty equals risk, and any CEO worth his/her salt would scale back on expansion plans until they have a clearer picture of what the future holds.
Unemployment will remain high and GDP growth low until capital investment is restored. The problem is: how?
The answer may sound simplistic, but we need to reduce uncertainty to provide business with a stable foundation on which to plan future investment. There are four possible solutions, but none of them are pretty.
The first is austerity: cutting government expenditure to match revenues. Austerity is important but on its own is likely to deliver even lower growth than at present -- and risks a deflationary spiral. Cutting government expenditure while private savings are being used to pay down debt, without an equivalent cut in tax revenues, would court disaster.
Raising taxes is another popular option: getting everyone to pay their fair share. Though the notion of fair share varies widely depending on who the speaker is -- and who pays their campaign contributions. Revising the tax code to achieve a more equitable distribution of the tax burden may contribute to long-term stability -- a fair tax system is more likely to stand the test of time -- but increasing tax revenues to repay national debt would also risk a deflationary spiral.
A third solution is massive public works programs similar to those undertaken by China during the GFC. Infrastructure projects directly stimulate local business and increase employment while also delivering savings in unemployment benefits. Government infrastructure investment, however, has a checkered history. Cost overruns and failure to meet revenue projections make private sector funding difficult to obtain. And government funding would further increase the national debt.
The fourth option, a soft default on existing debt, through inflation, is obviously tempting. Debasing the currency by selling Treasurys directly to the Fed, for example, would:
- Reduce national debt in real terms;
- Create a surge in investment demand for real assets as a protection against inflation -- lifting stock prices and the housing market;
- Bail out the banks, who are threatened by shrinking housing prices; and
- Give currency manipulators a sizable haircut on their existing Treasury investments and discourage further "pegging" against the dollar. China and Japan collectively hold more than $2 trillion in US Treasurys (Washington Post), accumulated to suppress appreciation of their currencies against the greenback and create a trade advantage.
An unwelcome result, however, would be a massive spike in inflation. At some point the Fed would have to raise interest rates sharply, effectively slamming the economy into reverse, in order to cure inflationary expectations. So we could defer the recession for now, in the hope that the economy is on a sounder footing when it re-visits us later.
The way forward
While each of the options has their downside, a combination of the first three seems to offer the best solution. Funding infrastructure investment through a combination of private sector funding, austerity cuts and increased taxes could avoid the risk of a deflationary spiral, with minimal increase in the national debt. It would also facilitate direct channeling of private savings into investment, reduce wasteful government expenditure (through an austerity drive) and could be used to justify a more equitable distribution of the tax burden (if we all benefit we should all expect to pay).
The fourth option, a soft default through inflation, should be seen as a last resort. And is probably why QE3 was not put forward at Jackson Hole last week. Once you awaken the (inflation) dragon, he can prove difficult to slay.