G20 Battle over Austerity

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The Obama Administration’s economic policy team used an op-ed in the Wall Street Journal to preview the President’s priorities for this weekend’s G20 meeting. Based on his advisors’ essay, President Obama will push for fiscal consolidation in Europe to be delayed until the “current recovery has become self-sustaining.” Under this logic, countries that can borrow should continue to do so to fund necessary stimulus, while countries that can’t will continue to be protected by “the financing that Europe and the IMF will provide.” In addition, the President will push emerging economies, which “account for two-thirds of global growth,” to strengthen sources of domestic demand. Reference in this regard was made to China’s recent decision to allow the Yuan Renminbi (CNY) to strengthen.

The message from President Obama to rich countries that can borrow at attractive rates is that they must do so to stimulate domestic demand, increase imports, and help to rebalance global growth. As explained in the Wall Street Journal essay, the President will emphasize that a commitment to reducing long-term deficits cannot come “at the price of short-term growth. Without growth now, deficits will rise further and undermine future growth.” The initial draft communiqué embraces this view by warning of an “uneven and fragile” recovery that leaves no room for complacency. At the same time, it expresses concern for the “market volatility” created by uncertain public finances. The language seems crafted as a compromise between the divergent views of the Obama Administration and German government. In recent interviews, economist Paul Krugman likely echoed the Obama Administration’s private musings when he ridiculed the Germans for embracing austerity while inflation is near zero and unemployment is 13%. Germany’s 10-year borrowing cost is 2.65%. The U.K., which can still access 10 year credit at relatively affordable 3.46% rates, has proposed budget cuts that are likely to be regarded by the Obama Administration as well beyond what is appropriate at this uncertain juncture. Ten year rates in Switzerland and Japan are under 2%.

The Obama Administration’s critique is entirely reasonable and embraced by macroeconomists who fear a “new mercantilism” emerging in Germany and other current account surplus countries. The President wants to ensure that global demand will “rest on many pillars going forward” and will make it clear to world leaders that the U.S. will not be the consumer of last resort, as it was in the years before the financial crisis. Both the Obama Administration and the Federal Reserve want to prevent global imbalances that arose from the symbiotic, producer-consumer relationship between the Asian and U.S. economies from reemerging. Not only does the President plan to make clear to world leaders that the U.S. will not reassume its role as the engine of global demand, he intends to emphasize his pledge to “double U.S. exports over the next five years.” While this commitment has been ridiculed as just another confusing chapter in the baffling Obama trade policy given the way the Administration had dragged its feet on free trade agreements, the policy goal serves a useful rhetorical purpose for the G20. Countries that expect to resume export-led growth strategies will be told instead to think about ways to accommodate greater net purchases of U.S. exports.

However, one gets the sense that pressure for continued stimulus reflects, in part, overconfidence in the salubrious effect of more government intervention. Recent data suggest this view is misplaced. On the same day that the economic team’s essay appeared in the Journal, the Department of Commerce announced that new home sales in May fell by 32.7%, to the lowest level in nearly 50 years and the fewest sales ever recorded in the month of May. Not only was the level of sales incredibly disappointing, but the median price of a new home also fell to 2003 levels. More price declines are likely in store as the supply of new homes stood at 8.5 months worth of sales, which is well above the price neutral level of six months of supply.

The obvious reason for the decline is the expiration of the homebuyer tax credit. Prospective buyers moved purchases forward to take advantage of the tax credit. This helped to stabilize (and even increase) prices, as the bids induced by the tax credit spared sellers from having to lower prices to generate sales. Eventually, those first-time buyers who were intending to buy had done so, which necessitated expanding the credit to cover all homebuyers, as was done in December, to maintain activity. At this point, so many sales have already been transferred forward in time that maintaining current price and sales activity levels would require an even more generous tax credit available to an even greater universe of taxpayers.

The declining returns from stimulus are also reflected in the fragility of the overall economic recovery. Fiscal stimulus converts idle financial resources into government debt that is used to finance transfer payments and other outlays to fund current consumption. While the consumption is likely to provide a short-term boost to activity, at some point fiscal stimulus is just as likely to compromise the transition to a “self sustaining” recovery as it is to aide it. Above a certain level, debt accumulation can change expectations about future tax rates and consumption levels, increase risk premiums, and create conditions for self-fulfilling panics. Once debt accumulation’s impact on private sector expectations are taken into account, the raw arithmetic of stimulus’ support for aggregate demand becomes a lot less compelling.

Over the past 30 years, several countries have undertaken austerity programs that actually resulted in economic expansions, contrary to the conventional wisdom. Ireland in the 1980s and Sweden and Canada in the 1990s dramatically reduced government spending and grew as a result. This was because fiscal consolidation in these circumstances signaled to the private sector that the government-to-GDP ratio was being permanently reduced. This led households and businesses to revise upward estimates of permanent income, which then led to increases in current and planned investment and consumption. It is not unreasonable to think that fiscal austerity packages that focus on reducing government spending could have a similarly positive impact on growth today. This is particularly true if the reductions not only increase private sector spending, but also reduce risk premiums and overall volatility (as experienced over the past few months).

The Obama Administration is right to worry about the reemergence of global imbalances, but its focus on continued stimulus spending ignores the diminished returns and heightened risk posed by this strategy. Fiscal accommodation was first launched more than two years ago. The boost to consumption has long since faded, as private sector expectations of future tax increases have caused private sector savings to increase. According to the Federal Reserve, over the past four quarters the government has required an average 9.2% of GDP in debt financing, of which 8.25% of GDP was provided by the private sector and 0.95% from foreigners. The private sector is now saving 8% more than it spends – roughly a 10% of GDP swing from the 2001-2008 average. The current expansion is indeed “fragile” but current data are consistent with the view that it is time to back off of stimulus and increase private sector spending through fiscal consolidation.