Sunday, June 13, 2010

G-20: the return to economic orthodoxy

The 'hawks' are back and took over the G-20. The final declaration* of the 4-5 June meeting in Busan states: "Those countries with serious fiscal challenges need to accelerate the pace of consolidation. We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions".

It seems that there has been a shifting attitude relative to the previous Washington communique issued on 23 April which insisted that demand stimulation policies" should be maintained until the recovery is firmly driven by the private sector and becomes more entrenched".

Historical experience in the 30s show that drastic cuts to public spending during a grave recession are not only ineffective in terms of reducing public deficits but also socially harmful. Restrictive fiscal policies - if not conducted wisely and gradually - may have opposite effects, as they might depress further the economy and reduce tax revenues, therefore further increasing public deficits.

So, what should be done? One possibility would be to wait that the economy recovers in order to allow central banks to use monetary policy to offset the contraction of economic activity resulting from budget austerity. But here again the 'hawks' ask for further budget cuts in the face of high unemployment and interest rates close to zero.

One might argue that the situation in Greece represents a serious warning against any further rise in public debt. But this cannot be taken as a general situation. Countries with high public debt are Spain and Greece (leaving aside the specific situation of Italian public debt being largely held by domestic financial institutions and households) ; they belong to the euro area and they have overvalued assets due to huge capital inflows in previous years. The risk is thus a prospect of deflation over coming years. However, for other countries, there is no objective reason to conduct immediately such policies. Ten year bonds in the UK yielded interests of 3,51%, in the US 3,21% and in Japan, 1,27%.

So where does this radical shift toward austerity stem from? the answer is that Finance ministers and governors of central banks of the G-20 are convinced that expenditure cuts would reassure investors. They just care about how world markets would react if the leading economies were not ready to make further sacrifices. But the idea that these sacrifices might be useful or even be harmful for large segments of the society does not count at all.

So the message is that if the leading economies will not pursue these virtuous policies along the lines of the G-20 and other organizations, it will undermine the fragile basis of economic recovery to satisfy hypothetical demands of investors for more austerity.

1 comment:

  1. Interesting to note that the US administration is more concerned about weak demand than on immediate fiscal consolidation. See the letter addressed by B.Obama to the G-20 on 16 June.