What should we make of the threat to shut down the US Government? Reversing the debt spiral is of course essential, at some point. What that point is, however, remains much debated. The bulk of government discretionary spending is on defence programmes. Funding wars is very expensive. And much of the rest is on social security. Non-defence discretionary spending is 12% of US GDP. That means cuts here ultimately are not going to solve the problem. What is required is structural changes to social security which are politically explosive. Alternatively lies the equally provocative proposition of increasing taxes or even more radically cutting taxes. Cutting taxes to stimulate growth was an argument popular in the Reagan era, now commonly viewed as discredited by history. The Laffer Curve speaks to the disincentive effects of higher taxes. This of course has a degree of truth, but the extension that lowering taxes will stimulate more growth actually increasing government tax revenues is highly problematic. The use of tax cuts to reduce budget deficits in current circumstances is an extremely contentious proposition, particularly to arch Keynesians such as Krugman. Martin Wolf of the FT goes through the numbers of what solving the budgetary problem through tax cutting versus tax increases looks like here. But increasing taxes, what most would consider the more reasonable solution is hugely problematic. Even at the best of times tax increases are political dynamite, yet should you increase them when the economy is weak? This mirrors another heated debate, does cutting budget deficits boost growth in a downturn. The contentious former adviser to Clinton and Obama described the proposition as oxymoronic. Summers is a lightning rod, seen by many as having changed positions in the Clinton years to support Wall Street interests. It is interesting to note that of the voices demanding deficit reductions and tighter monetary policy the absence of some of the major global investment banks. These are seen by some as principle beneficiaries of expansionary government policy, particularly in the US. In play in this debate is both the functioning of the macro-economy, and the fundamental role of the state. The US now sees itself as gridlocked and without an effective policy. The IMF has now come out and rebuked it for this failure.
Mirroring this is what to make of the European bailouts of the peripheral states, the so called PIGS. Portugal has now followed Ireland and Greece in requiring external support to cover its debts. The price of those ‘bailouts’ is massive fiscal cutbacks. Much as Summers says with respect to English policy, these cutbacks now seem to be producing his predicted major economic contraction in those countries pursuing them. Retail sales figures just released in the UK show the greatest fall in total sales since the data series commenced in 1995.
The question about Greek Debt is increasingly not if it will be restructured but when. Be under no illusion. The issue is not the health of the ‘peripheral economies’ but who is responsible for supporting core banks and the ECB exposure to those economies. Is it the German tax payer? Why shouldn’t the banks take the hit? The alternative, as we saw in sub-Saharan Africa is extended pain at street level. Of course corrupt or inept leadership needs to be firmly dealt with. Corrupt leadership can hide behind street protests. But democracy makes this all very hard. In Portugal, the EU, ECB, and IMF are seeking to extract a pre commitment by all political parties to the terms of the bailout deal ahead of coming elections triggered by the failure of the government to be able to pass the required measures. On the other hand Finland goes to elections this weekend, with voters capable of dealing a blow to requests that taxpayers from healthy economies cover the debts of the ‘periphery’.
Currently the markets see Spain as not vulnerable. The cost of insuring the risk of bank default is declining. Whilst stress tests being implemented again on European banks are likely to show weakness, explaining in part the strength of resistance to writing down debt, as the Financial Times reports, investors are broadly more confident in European banks. The initial interest rate rise by the ECB may not impact the fragile Spanish property market, as in absolute terms rates are still relatively low. But what if the ECB ‘normalises’ interest rates from the current 1.25% to 2-3%? Not all market observers are as optimistic as recent market price movements suggest, Munchau for example at the Financial Times. But for now German growth seems solid. For all the media and blogging airtime given to the debt question on both sides of the Atlantic, is it really now just a sideshow for the markets, or are investors simply complacent? Problems in markets tend not to be triggered within such long focused on problems. For many writing off a portion of debts such as those of Greece would be seen as resolution, good news. Investment risks generally arise from exogenous shocks such as the Japan earthquake, or tipping points within complex systems, such as geopolitical risks triggered by food/oil inflation, combining with challenges such as the Western World’s debt burden. We remain alert.
