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September 2010 The great financial crisis, the (brief?) revival of Keynesianism, and the question of public debtThe Great Financial Crisis (‘GFC’) from 2007 seemed, at first glance, to have precipitated a rather dramatic shift in economic thinking, at least among the actual policy-makers, if not so much within academic economics. All of a sudden, the spirit of John Maynard Keynes appeared to spring to life again, after having been largely exorcised from policy thinking, particularly in the Anglophone world, since the end of the 1970s. At least this was true at the level of policy (theory is another matter). This was evidenced in a widespread recognition and embrace of the fact that monetary policy implemented by means of merely setting a short rate of interest—which had become the conventional mode of monetary policy conduct—was inadequate to the task of macroeconomic management, at least in the crisis conditions of the GFC. There was a return to activist fiscal policy for managing, or at least influencing, aggregate expenditures in economies. There was also widespread recourse to unconventional and more expansive monetary policy interventions, beyond the mere setting of a short interest rate, effectively adding additional policy instruments to the monetary policy arsenal. But almost just as suddenly this Keynesian turn has confronted something of a crisis itself, or so it is commonly characterised by many participants in public debate: a supposed crisis of public debt non-sustainability, due to widened public sector deficits, which in turn are partly attributable to the activist fiscal policy responses to the earlier financial crisis of the private sector. I don’t wish here to revisit the question of the causes of the GFC. The literature on that subject has reached such proportions that to call it a ‘cottage industry’ would be a gross understatement; more like a massive industrial complex. Rather, I want to address two broad issues. First, how should one assess the Keynesian turn in response to the GFC; was the shift towards activist fiscal policy appropriate; is it really in the spirit of Keynes’s approach to economic management; and what is the significance of these policy issues at the level of economic theory? Second, what precise meaning can we give to the notion of ‘public debt sustainability’; what are the desirable trajectories for public debt over time; do we have reason to be concerned about the dynamics of public debt in the current global situation and into the future? HOW ‘KEYNESIAN’ WAS THE KEYNESIAN POLICY TURN?
In raising here the question of how Keynesian the recent ‘Keynesian’ policy turn really was, I don’t wish to go into great detail, or even present a reasoned argument. Rather, I will make a number of assertions which I believe could be defended with argument, given sufficient time or space. Much of the supporting argument was sketched in my August 2009 lecture in The University of Sydney Key Thinkers Series (published as Aspromourgos 2009). One may note as the point of departure here that those who have presented themselves as defenders of a ‘Keynesian’ response to the GFC have generally been advancing the view that a large, discretionary fiscal stimulus, but a temporary one, is required to adequately respond to the consequences for real economic activity and growth of a temporary but very deep and serious financial shock. In the process, debt/GDP ratios should be allowed to continue to rise (at least for some countries), though in the medium term (three to five years out) these ratios should be stabilised at some desirable levels or other. Would Keynes have endorsed this view? Who can be sure? But probably the answer is yes. But this kind of very limited fiscal activism needs to be seen in the wider context of Keynes’s general theoretical and policy views on the character and performance of the competitive capitalist economy. At this more fundamental level, Keynes argued that there were no reliable, systematic forces at work in a competitive economy, which would automatically tend the system towards full employment or zero involuntary unemployment, in either the short run or the long run; that in mature capitalist economies there was likely to be a tendency towards chronic unemployment or underemployment; that monetary policy alone would be inadequate as a policy intervention in response to these conditions; and that as a consequence, what was required was a permanent expansion in the size and role of the public sector. It will be evident that in this framework of belief, short-run fiscal activism appears as a rather second-order issue and policy. A permanent problem of competitive capitalism (persistent aggregate demand deficiency and unemployment) requires a permanent policy solution (a shift in the balance between public and private expenditures). Furthermore, Keynes was not very favourable towards debt financing, certainly of consumption expenditure, though debt financing of public investment was fine, so long as such capital works were self-financing over the life of the investments. He was largely relying on expanded government outlays financed with a highly progressive tax system to effect the required support for aggregate demand. The ‘Keynesianism’ of many contemporary defenders of fiscal stimulus is of a much more limited kind: a sort of short-run Keynesian combined with a belief that the system is self-correcting in the long run in ways which Keynes certainly denied. A recent defence of US fiscal strategy by Lawrence Summers (2010), Mr Obama’s chief economic adviser, is a good example of this kind of short-run Keynesianism combined with long-run orthodoxy. I may add one final comment here on the role of the public sector in the recent context of the GFC-induced global contraction. It is important in relation to this not to miss the wood for the trees. In the first instance, what was guaranteed to ensure that the crisis of 2007 forward would not impact aggregate activity levels and employment as adversely as the 1930s crisis was that much larger public sectors in the recent crisis acted as a automatic buffer against the negative aggregate consequences of private sector contraction, via the relatively larger share of public sectors in GDP, and the operation of substantial ‘automatic stabilisers’. By ‘automatic stabilisers’ I am referring to the endogeneity of government outlays and revenues (and hence also overall budget balance) with respect to aggregate activity levels or growth: lower activity levels or growth tends to automatically expand some categories of outlays (for example, unemployment benefits) and contract many sources of revenue (for example, income taxes). These buffer and counter-cyclical roles were in play independent of any possible discretionary fiscal stimulus. THE CONCEPT OF DEBT SUSTAINABILITYThere are a variety of concepts of sustainable and of optimal public debt trajectories which one could consider but I want to focus on one which seems to me particularly robust, and which is traceable back to Domar (1944; for other concepts, see Aspromourgos, Rees & White 2010). This particular concept captures the conditions under which the ratio of public debt to Gross Domestic Product (‘GDP’) remains constant over time (or does not rise). So that if we suppose the economy in an initial situation of having a desired debt/GDP ratio (or at an upper bound of debt/GDP, beyond which it is undesirable for the ratio to rise), this concept tells us what is required in order to keep debt ‘on target’ (or within targeted bounds).
Given an initial debt/GDP ratio (say, at the beginning of 2010), it is evident that keeping debt within target requires that the growth rate of debt per annum (or say, this year) be equal to or less than the growth rate of GDP per annum (or this year). The growth rate of debt per annum in turn will be equal to the budget deficit per annum—that part of the government’s expenditures which is not covered by tax revenues—divided by the initial level of outstanding public debt previously issued. The budget deficit in turn can be divided into the ‘primary’ budget deficit plus interest payments on the outstanding stock of public debt previously issued. The primary budget deficit is government expenditures net of government interest payments on outstanding debt and net of government revenues. Without getting too technical, it may be parenthetically noted that apart from issuing debt (bonds and so on), governments can finance deficits by issuing or printing money. This may be treated as equivalent to financing with seigniorage revenues, so that implicitly it is included under government revenues in the primary budget balance. (‘Seigniorage’ refers to the difference between the face value of money issued by government to the private sector and the cost to government of producing that money, the cost being a very tiny fraction of the face value.) There are also other government revenues which are not tax revenues; for example, revenues from user charges for government services. One could write out algebraically expressions for the budget deficit, the growth of debt, and the growth of GDP, and formally manipulate these in order to arrive at conditions for debt sustainability. But allow me instead to focus on the limiting case where the debt/GDP ratio is kept constant over time and merely assert a resulting standard formula for public debt sustainability so understood:
where d is the primary budget deficit as a percentage of GDP, g is the annual GDP growth rate, i is the interest rate paid on public debt, and b is the constant debt/GDP ratio which is to be maintained over time in this thought experiment. The logic of this formula is reasonably intuitive. For any given (and positive) ratio of public debt to GDP (b), the public sector primary deficit, as a percentage of GDP, that is consistent with keeping that debt/GDP ratio stable is a negative function of the interest rate on debt and a positive function of the growth rate of GDP. Why? Higher interest increases the budget deficit, due to higher payments on previously issued public debt, so that to keep debt growing at just the GDP growth rate, the primary budget deficit must be reduced. Higher GDP growth enables higher growth of debt while keeping the debt/GDP ratio constant, so that the primary deficit may be increased. If the interest rate exceeds the GDP growth rate, the sustainable primary deficit is negative; that is to say, sustainability requires a primary budget surplus. In the special case where the interest rate just happens to equal the GDP growth rate a balanced primary budget is required: under this condition, the growth rate of debt due to interest payments on previously issued debt alone just equals the growth rate of GDP, so that a zero primary deficit is required. To gain some sense of plausible empirical orders of magnitude for these variables, let us suppose that the initial debt/GDP ratio which one wishes to maintain unchanged over time is 50 per cent (much higher than Australia’s current ratio, but much lower than that of many other developed economies). Suppose also that the nominal interest rate on public debt is 7.5 per cent and the nominal growth rate of GDP is 5.5 per cent (reasonably plausible figures for Australia). Then the formula is telling us this: if you wish to maintain debt/GDP at 50 per cent, and the difference between your GDP growth rate and the interest rate on your debt is minus 2 per cent (5.5 per cent minus 7.5 per cent), then you need to run a primary deficit of minus 1 per cent (50 per cent of minus 2 per cent); that is to say, a primary surplus equal to 1 per cent of GDP. Note that the total budget deficit as a percentage of GDP will be minus 1 per cent (the primary deficit) plus 3.75 per cent (the 7.5 per cent interest rate on debt times the 50 per cent debt/GDP ratio); that is to say, a total deficit equal to 2.75 per cent of GDP. Note also, therefore, that for a positive, sustainable debt/GDP ratio, the total budget deficit—primary deficit plus interest payment on debt—is necessarily positive, so long as GDP growth is positive. This is simply a reflection of the fact that if GDP growth is positive, a constant debt/GDP ratio requires that public debt also grow, which in turn requires an overall public sector deficit. But it points also to an important truth. To the extent that the private sector wishes to hold government securities because of their status as a safe or riskless asset (more on this below), if there is a growing private demand for government bonds over time, government must on average run overall deficits, if this private demand is to be satisfied.
Apart from this function of providing private sector portfolios with access to a riskless financial asset, the government debt market also thereby fulfils the valuable function of generating the magnitude of the riskless rate of return, a benchmark with respect to which the wider set of yields can be set, by adding in premia to reflect various kinds of risk to which the wider set of available assets are exposed. On a particular Australian note, when Peter Costello, as federal Treasurer some years ago publicly floated the possibility of extinguishing all Australian government gross debt, operators in the debt market were aghast and publicly opposed it. (In fact, I doubt that Mr Costello was really serious about pursuing this possibility. I think it was merely a kind of publicity stunt, to enable him to trumpet his supposed virtues as an economic manager.) These are the kinds of people one would expect normally to be on side with such conservative economic policy. No doubt their stance was partly driven by self-interest (since they make handsome livings trading public debt). But it was also justified by the very good reason that closure of the Australian government bond market would compromise the orderly pricing of the wider range of financial assets. Incidentally, the much vaunted low federal public debt position, in which the conservative governments of 1996–2007 left Australia when Labor returned to power, was an outcome more due to the privatisation of public assets than to the achievement of genuine budget surpluses. To that extent, it was due to a reshuffling of public assets and liabilities, not an increase in the net worth of the Australian public sector. Three further general points may be made. To reduce debt/GDP ratios, rather than merely stabilise them, the above clearly enough implies that smaller budget deficits or larger surpluses than those given by the above sustainability formula are required. Second, while debt/GDP ratios are the common focus of public discussion of public finance sustainability, it would be foolish in contemplating financial sustainability to take one’s bearings from one pertinent financial ratio alone. If there is one ratio which should be of primary interest, rather than debt/GDP, the focus should be on the cost of debt servicing—interest payments on outstanding debt—as a percentage of recurrent government revenue. Using the symbols employed in our formula above, this is given by ib/r, where r is the share of taxes or government recurrent revenue in GDP. One sees then that rising b (suppose with i given) is then sustainable, at least for a time, if r can be increased in line with rising b. (I say ‘for a time’, because obviously r cannot rise indefinitely either.) And finally, note that the sustainability formula tells us what configurations of interest, growth and primary deficits are sustainable, for any given desired debt/GDP ratio; it does not tell us what the desirable debt ratio is. PUBLIC DEBT TRAJECTORIES TODAYLet me now relate these ideas from Keynes’s economics and from the logic of debt sustainability to the current situation of burgeoning debt/GDP ratios. The concrete catalyst for the recent intensification of the public debate around public debt sustainability has been the Greek situation. Here, one may notice first that the Greek situation, and to some extent that of other southern European countries is illuminated by attending to the above-noted distinction between debt/GDP ratios and debt-servicing/recurrent-revenue ratios. The crisis of the PIIGS (Portugal, Ireland, Italy, Greece, Spain) in part is a compliance failure of the tax systems of those countries: stabilising the latter ratio (ib/r) can be achieved, at least in part, by increasing r, as well as by reducing b. In the longer run of history and in the wider context of the developed world as a whole, the secular tendency towards enlargement in the size of the public sector as a proportion of the economy as a whole was rendered sustainable by enlargement in the tax share of GDP, and this also enables sustainability of higher b.
Other dimensions should also be taken into account, in a non-mechanical, multidimensional treatment of public debt sustainability. In a world of open economies with capital flows between national economies, a public sector deficit will either be funded by selling public debt to the domestic private sector of the economy or to foreign entities. Consider the situation of Japan. It has a public debt/GDP ratio close to 200 per cent, much higher than Greece. Why then is it not being hammered by the debt market the way Greece has been in recent times? In fact, notwithstanding this very high debt/GDP ratio, more than 90 per cent of Japan’s public debt is domestically held, reflecting the big surpluses of income over expenditure (that is, high saving rates) of the domestic Japanese private sector, now and in the past. The dynamics and psychology of the debt market are quite likely to be rather different depending upon the proportions in which public debt has been domestically funded and foreign funded. The ‘internal’ financing which the Japanese government has been able to rely upon has been rather ‘passive’, and has enabled it to face much less constraints or pressure from the markets than Greece, though as Japanese population ageing begins to bite, this situation could change rather quickly. But undoubtedly the key further dimension to be taken into account, of the utmost importance to understanding the European situation, is whether public debt is denominated in a currency issued by the State issuing the debt. This is the peculiarity of the European situation: the public debts of the Eurozone nations are denominated in a transnational currency which is not able to be issued by those nations. (Indeed, it is unable to be issued by any government, strictly speaking—only by the ‘independent’ European Central Bank.) In effect, the public debt of Greece and the others in debt trouble is denominated in a ‘foreign’ currency. Nations like the United States, Britain and Australia, on the other hand, are issuing debt denominated in terms of an asset which they can freely create ex nihilo. And also important, in the case of the United States, the currency asset in which it denominates its debt is the overwhelmingly most favoured international reserve currency, so that there is a deep underlying global demand for US-dollar-denominated safe assets. The peculiar freedom of manoeuvre which this gives those governments, vis-à-vis private debt-issuing entities and governments obliged to issue debt in foreign currencies, is that issuing a government security entails an obligation to make a series of future payments in an asset (domestic currency) which that government can freely create out of nothing. (It is this which is the primary reason for such securities being riskless—default-risk free—in terms of their nominal value, when held to maturity.) One might conclude therefore, that so long as their economies are not pushing up against resource supply constraints, issuing public debt faces no real constraints for these governments. But even putting aside supply constraints and inflation dangers, this is not quite true I think. In the kind of monetary policy regimes in place in the contemporary developed world (interest-rate-setting monetary policy), liquidity in the form of ‘outside money’ injected into the private sector—say, for our considerations here, in order to repay public debt—if it is not desired to be held by the private sector as a whole, will be automatically ‘drained’ by the day-to-day market operations of the central bank, in exchange (mainly) for government securities. ‘Outside money’ is liquidity which can only (legally) be created by government or its agent, the central bank (that is to say, it cannot be created by the private sector): currency or the reserves of private financial institutions held at the central bank. The crucial question then is whether the private sector is willing to hold the resulting increasing stock of public debt, in some form or other of government securities. So we’ve gone round in a circle here: public debt repayment injects outside money; if undesired, it is ‘drained’, leading the private sector back into government securities holding; then what, if the private sector also does not wish to hold such a quantity of securities? This is the real problem or constraint that the growth of public debt supply, arising from a combination of recession and fiscal stimulus, poses for governments like the United States or the United Kingdom: if the ensuing growth rate of the supply of public debt faces private sector resistance, in the sense that the growth of private demand for such debt is insufficient at prevailing yields, then there will be upward pressure on interest rates, which will feed back on sustainability and the real economy (for a fuller account, see Aspromourgos, Rees & White 2010). Recall the sustainability formula above: higher interest rates on government debt require smaller budget deficits to stabilise debt/GDP ratios.
But so far, the debt trajectories we are witnessing have not led to such pressures on yields on long-term government bonds for countries like the United States, United Kingdom or Germany. On the contrary, the fear induced by the crises has strengthened the private demand for highly rated government bonds. Nor is there any evidence, at this point, that unorthodox monetary policy conduct is in danger of causing inflation. The balance of risks on that front points to deflation as the greater danger, if concerted fiscal contraction is pursued. As Martin Wolf (2010) has recently commented:
I said above (second introductory paragraph) that the widened public sector deficits since the GFC are ‘partly’ attributable to the fiscal-activist response to the crisis. In fact to a considerable extent the widening deficits have been endogenous to the global contraction itself. That is to say, they have been a result of those automatic stabilisers mentioned above (at the end of the first section), as well as discretionary policy decisions in favour of fiscal stimulus. They have been partly due to the contraction in private spending causing contraction of GDP growth, in turn inducing falls in government tax revenues and increases in some elements of government social expenditures. In this sense, the widening public deficits have been in significant part due to the widening private sector surpluses, as private spending fell and private saving rose. Reserve Bank of Australia Governor Glenn Stevens made the point in a recent speech (20 July 2010):
Yeates goes on to quote Stevens: ‘Generally speaking, the public balance sheet has played the role of a temporary shock absorber as private balance sheets contracted’. This is another way of making my point above, that widening private surpluses, in significant part, have caused widening public deficits. To reiterate that point, in a closed global economic system the private sector as a whole can only have a surplus of income over expenditure—let us say, with a view to repairing debt-laden private sector balance sheets—if the public sector as a whole runs a deficit. Some public sectors in the global economy certainly must rein in their deficits (notably, PIIGS). But if all do so, this is a recipe for economic disaster. And that disaster will very possibly be self-defeating with respect to the magnitudes of public sector deficits, as the resulting economic contraction endogenously increases public deficits (see the parenthetical note on automatic stabilisers at the end of the first section above). SOME CONCLUSIONSIf concerted fiscal contraction or ‘retrenchment’ is pursued by all major countries and the Eurozone, and if this is indeed contractionary for national economies, and by extension the global economy, as Keynesian-inclined economists would predict, then it threatens double-dip recession. To the extent that such a recession will damage the balance sheets of corporate entities and financial intermediaries in particular (many still in a weak position post-GFC), it risks also generating further financial disturbances. I therefore think that a shift of fiscal stance such as to generate a net negative impact on global demand should be rejected—particularly for countries like the United States, the United Kingdom, Germany, China, and perhaps Japan—while at the same time planning for more sustainable budget balances in the medium term. Apart from the possibility of upward pressure on interest rates, perhaps the strongest argument for stabilising and perhaps reducing debt ratios in the medium term, one is sorry to have to say, is so as to ensure that governments are well placed (as Australia was in 2007–08) to make a robust fiscal policy response to the next financial or other economic crisis, whatever its source might be! The ‘PIIGS’ of course must pursue fiscal retrenchment without delay; but the pain of austerity for them will be much greater if this has to be undertaken in an environment of more global recession. Those who argue that universal fiscal retrenchment by all the majors would not be contractionary must rely on some combination of: confidence effects whereby lower public deficits somehow induce greater optimism in the private sector, stimulating a compensating increase in private spending (not plausible in my view, though of course it can’t be ruled out as impossible); easier monetary policy being able to offset fiscal tightening (but there’s not much scope left for this, with official interest rates already very low); or export-led growth, possibly induced via exchange-rate effects of easier monetary policy (but this is globally incoherent, to the extent that not every country can pursue this strategy simultaneously).
Furthermore, with regard to the last of these possibilities, export-led growth is not a strategy one expects from large and mature economies like Germany, who should rely on internal sources of demand for sustaining growth; it is a strategy for developing and small economies at best. In this regard, China (which is an underdeveloped economy) has played a more responsible role in response to the GFC than Germany, to the extent that China has shifted towards expanding its domestic demand and expenditures. But the addition of a cautionary note is in order. No one can know for sure that fiscal stimulus will not cause more problems than fiscal retrenchment, in the current global situation. All one can do is form a judgment of the balance of risks. There are no prizes for Monday morning quarterbacks: what to do ex ante is the question. And it is true that the influence of a currently rather precarious private sector and market psychology and confidence makes the situation potentially somewhat fraught. Consider this. Public debt sustainability is a negative function of the average interest rate on public debt. Suppose that increased market fears that public debt is unsustainable, rational or otherwise, feed into lower pricing of public debt as higher risk premia are factored into interest rate yields on such debt. This in turn undermines sustainability, as those interest rates at which governments must roll over debt rise. Hence an element of self-fulfilling psychology can come into play. (This certainly happened to Greece.) One could say, only half-jokingly (so half serious), that the private sector perhaps looks at the panic which has affected European governments and governance, and says to itself: ‘The GFC showed that we didn’t know what we were doing; now, governments and government reactions evidence that they don’t think they know what they’re doing either; we’re all going to hell in a hand basket!’ That is to say, a loss of confidence by the private sector in general and the debt markets in particular can feed on itself. As was shown above by recourse to a little algebra, the sustainability of public deficits and debt depends upon interest rates on public debt (and hence the pricing of government securities) relative to the growth rate of GDP. Suppose there is a loss of confidence by the markets, for example, because they perceive, perhaps correctly, that EU governments and the bosses of the Euro-land bureaucracy as little know what they are doing as the private sector, as evidenced by policy panic. This puts downward pressure on government bond prices and hence upward pressure on yields, which in turn diminishes sustainability, which might further undermine private sector confidence, and so on. But allow me to conclude with this further warning, from the other side of the argument. Conservatives who would very much enjoy a failure of government fiscal activism to achieve it purposes (combined with other policies of course), or would enjoy seeing it generate a crisis of its own, should be careful what they wish for. If a competitive capitalist economy indeed has no reliable automatic mechanisms for keeping involuntary unemployment tending towards zero (and, it may be added, if financial markets have no reliable self-correcting adjustment mechanisms in the absence of strong and stronger regulation), then the incapacity of government to correct for market failure would begin to look like an impossibility of successfully managing a capitalist economy at all—with a view to meeting some quite basic human socio-economic objectives (full employment, the preservation of people’s savings and retirement incomes, and so on). This takes us back to Keynes: he was aiming to save capitalism from itself; by active management of capitalism, to preserve its strengths while overcoming, or at least meliorating, its evident weaknesses. The alternative to the success of such management might be the collapse of liberal society itself. Perhaps this is now not so clearly understood by most of the self-proclaimed defenders of liberal capitalism. The centre of the policy and political spectrum has shifted so far right since Keynes’s time (more particularly, since the 1970s) that he now appears to many as being a considerable way out on the left of the political spectrum. But Keynes, correctly, was conscious of his position as being an alternative, in his time, to a political response much further to the left (official Communism). That latter political option might now be dead; but it would be unwise to assume that extremes of either the right or the left could not have political life breathed into them by a chronic failure to deal with capitalism’s failures in a manner consistent with the preservation of a liberal society, bound by the rule of law. REFERENCESAspromourgos, T. 2009, ‘John Maynard Keynes and the preservation of liberal capitalism’, Australian Quarterly, vol. 81, no. 4, pp. 17–24. Aspromourgos, T., Rees, D. & White, G. 2010, ‘Public debt sustainability and alternative theories of interest’, Cambridge Journal of Economics, vol. 34, no. 3, pp. 433–447. Domar, E.D. 1944, ‘The “burden of the debt” and the national income’, American Economic Review, vol. 34, no. 4, pp. 798–827. Summers, L. 2010, ‘America’s stance on the recovery is the only sensible course’, Financial Times Asia, 19 July, p. 9. Wolf, M. 2010, ‘Why the battle is joined over tightening’, Financial Times Asia, 19 July, p. 9. Yeates, C. 2010, ‘Reserve defends stimulus legacy’, The Sydney Morning Herald, 21 July, p. 5. Tony Aspromourgos is Professor of Economics at The University of Sydney. This is a revised version of an address to The Sydney University Economics and Econometrics Society, 11 August 2010. View other articles by Tony Aspromourgos
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