by Chidem Kurdas
As the financial crisis shades into a global recession, governments all around are reaching for fiscal stimulants. These public programs against sagging economic activity come at a time of falling tax revenues and massive spending on financial bailouts. So governments worldwide face growing budget gaps.
We have barely started to come to terms with what this means for economies and financial markets, let alone politics. The current conventional wisdom, expressed for instance in a column by Paul Krugman in the New York Times, is that “when depression economics prevails, prudence is folly.” In other words, spend, spend, and then spend some more. You can worry about deficits later.
Judging from past crises, the magnitudes will be large. In a recent report, Alex Patelis, economist at Merrill Lynch, points out that fiscal costs during banking crises average 13% of GDP. The US deficit for 2009 is forecast at over $1 trillion, or 7% of GDP. That number is likely to go much higher, according to Mr. Patelis, because the estimate includes only already announced programs.
He puts euro area budget deficits at over 4%. European deficits were limited by the Maastricht Treaty, but no more. And Japan, already heavily in debt from Keynesian programs during two decades of economic malaise, is spending generously again to contain the present crisis.
The immediate impact of widening government deficits is to increase the supply of sovereign debt. That will push up yields. Right now US Treasury yields are at extreme lows, reflecting extraordinary demand from investors who piled into T-bills in their flight from risk. But demand for Treasuries will weaken when risk aversion reverts to the historical mean, while the supply of government paper grows.
The US was able to borrow at low rates in the past decade because other countries had surplus savings to lend. With almost all governments in deficit mode, it is hard not to conclude that borrowing costs will go up. Will this dampen private sector borrowing? Mr. Patelis suggests that the old crowding-out question is worth another look.
Timing is the pivotal factor here. Central banks have opened up the monetary sluices to get banks to lend. One can argue that even if government borrowing ups the cost of capital, by the time it does so economic activity will likely be robust. By then the problem may be inflation–another long-term implication, together with rising taxes, of large deficits.
Mr. Krugman writes that fear of red ink, though usually a virtue, becomes a vice if it stands in the way of the government spending necessary to counteract the downward economic spiral that we’re in. It is surprising how powerful this Keynesian argument remains despite immense economic changes since the 1930s. Nobody has an alternative remedy.
But that should not be a mandate to ignore the potentially huge adverse consequences, especially as political choices may very well worsen them. For instance, Mr. Patelis argues that government interventions and the crisis will likely lead to lower productivity, but it depends on what kinds of public programs are put in place.
Infrastructure investments may boost productivity—unfortunately, these are a great temptation for politicians. A public discussion and better awareness of the issues might help reduce global pork barrels and limit the damage.