The Fiscal Beauty Contest Starts

The realisation that endless government borrowing could not be sustained really started with the (still unfinished) Greek crisis. As the risks of sovereign debt became apparent, risk aversion, and sometimes panic, have gripped the markets for government debt.

In the title of this post, I mention a beauty contest. However, in some respects, what we are looking at is not a fiscal beauty contest - but a fiscal 'least ugly' contest. I proposed that the world was about to enter a beauty contest some time ago as, whatever happens, many of the major debtor nations are going to have to keep borrowing for a while yet, and that means ongoing access to credit. I highlight this, as it looks like the UK is about to embark on a path of radical change in fiscal policy, with a firm and decisive attempt to seek to deal with the UK's fiscal problems:

George Osborne braced the country for cuts in government spending of up to 20 per cent as he laid the ground for an austerity programme to last the whole parliament.

The Chancellor announced an unprecedented four-year spending review in which every Cabinet minister will have to justify in front of a panel of colleagues every pound they spend.

Mr Osborne said the task ahead represented “the great national challenge of our generation” and that after years of waste, debt and irresponsibility it was time to rethink how government spent its money.

There is, of course, a huge gap between rhetoric and achieving action on the ground, and this means that such announcements need to be treated with caution. The inspiration for the fiscal retrenchment is Canada in the 1990s, and the process will involve a careful review of each element of government expenditure, including asking the vital questions of whether any activity might be necessary or contribute to the economy overall. Whilst a similar process worked for Canada, this was undertaken in less stressed times, so that it may be more difficult to emulate the Canadian example than might be believed.

The interesting point about the case of the UK is that they are increasingly faced with little choice but to cut back savagely. Whilst not personally having any respect for the ratings agencies, I nevertheless accept that they impact markets. As such, the latest from Fitch highlights the necessity of action in the UK:

Britain's debt problems returned to the spotlight Tuesday after Fitch Ratings warned of the need for bigger austerity measures in a report that rattled investors but could help new Prime Minister David Cameron justify severe spending cuts to a worried public.

In its first major statement since Britain's Conservative and Liberal Democrat parties formed a coalition government last month, Fitch warned the U.K. "faces a formidable fiscal challenge" and needs to be more ambitious in cutting its debts. The warning comes as new U.K. Treasury chief George Osborne prepares on June 22 to unveil emergency measures to cut Britain's budget deficit, which at more than 11% of gross domestic product ranks among the largest among advanced countries.

The point of the Fitch report is that, in the least ugly contest, the UK still has a long way to go. However, as each country seeks to beautify their balance sheet, the pressure on other countries to follow suit will increase. In other words, even if the UK seeks to be fiscally sound, other countries will be forced to outdo the UK, as they too seek further funding. This is from the same article quoted earlier:

"As more European countries respond to market pressure by tightening fiscal policy more aggressively than originally planned … there is a risk that the U.K.'s existing deficit-cutting targets begin to look distinctly weak," Fitch analysts said.

This coordinated shrinkage in debt growth follows the coordinated growth in debt, or going from feast to famine. Whilst the view of this blog has always been to recognise the dangers in the growth of debt, and the absolute necessity to reform to fiscal responsibility, the coordination of the fiscal consolidation over so many economies presents significant dangers. In particular, the consolidations will force a drop of activity over many economies simultaneously, and with that drop in activity, each country that consolidates will see a major drop in imports, further ratcheting each economy down.

This potential systemic shock over many economies risks a collapse in confidence, and therefore a hard economic 'undershoot'. By this, I mean that the drop in activity will in turn undermine confidence more broadly than the real consequences of austerity might reasonably point to. This might further ratchet down economic activity. Just as the debt fuelled activity created massive over-confidence, the collapse in debt driven 'growth' might create under-confidence. And to add to the potential nose-dive, there is the talk of fiscal retrenchment in Japan:

Despite the prime minister's hair-raising words [that Japan will face a sovereign debt crisis if it continues on the current path], markets did not bat an eyelid, with the Japanese yen, the Nikkei stock market index and Japanese government bonds unmoved.

"Fiscal austerity measures are long overdue," said Chris Scicluna, deputy head of economics at Daiwa Capital Markets in London.

He forecasts that the government's budget deficit will be 8% of GDP this year, a number that Mr Kan has promised to reduce to zero by the end of the decade.

Having said all of this, the current move to fiscal austerity is not as severe as is popularly believed. It might be noted that Japan is not planning to pay down debt, but just slow the accumulation of debt. The same might be said for most of the so called austerity measures, as can be seen in the following chart:

The problem is this. The beauty contest is now enacted, and the only possible result is an ever fiercer spiral of fiscal consolidation, with the effects of this spiralling economies ever deeper into recession/depression. The chart just shows that there is still a long way to go to achieve a realistic and long term fiscal correction. The beauty contest will ensure further measures will change the shape of the chart.

The trouble is that, having splurged in the wake of the financial crisis, having simultaneously strained fiscal positions towards breaking point, there is nowhere left to go. Had it been the case that only a few small economies had built up so much debt, the world economic system might have been able to absorb the retrenchment, albeit with some pain. However, this is not what happened, and the collective market awakening to the risks of sovereign default can not be turned back. Even Japan, with its willing army of domestic savers, is twitching.

Then there is the US. With the 'safe haven' and reserve currency status, the US has chosen to remain on the path of ongoing growth in debt and spending. There is further talk of more more fiscal stimuli. The US is getting into ever deeper trouble, all the time relying on the safe haven and reserve status to last to eternity. In my last post, I discussed the risks in being perceived as a safe haven, and this is the latest news on the US trade situation:

WASHINGTON — The U.S. trade deficit rose to the highest level in 16 months as exports fell for the second time in three months, a potentially worrisome sign that Europe's debt troubles are beginning to crimp American manufacturers.

The Commerce Department said Thursday the trade deficit widened to $40.3 billion in April, up by 0.6 percent from March. U.S. exports dropped 0.6 percent, while imports declined by 0.4 percent.

U.S. manufacturing has been a standout performer as the U.S. recovers from the worst recession in decades. But the concern is that Europe's debt crisis will slow growth in that part of the world and dampen demand in a key U.S. export market.

For April, exports slipped to $148.8 billion, with demand for U.S. farm products falling by $647 million and weakness spread across a number of manufactured goods from electric generators to industrial machinery and aircraft engines.

This latest news serves to highlight the dangers described in my last post, that the safe haven status is a danger to the US economy. The US is in very deep trouble, and the safe haven and reserve currency status are encouraging them deeper into a quagmire. As long as the world keeps buying US treasuries, they seem willing to keep deepening the fiscal hole, all the while importing and consuming based upon debt growth. At some stage, the markets must realise that the beauty of the US has faded, and that in reality it is looking both tired and haggardly. The trouble is, the US is still deeply entrenched in the (neo-) Keynesian dream.

In the world of the (neo-) Keynesians, the answer is not to consolidate, but to continue government borrowing, to prevent a choking of 'recovery'. No doubt, in the future, as the inevitable consequences of the consolidation take place, they will blame the problem on the fiscal consolidation, rather than on the fiscal splurge and consumer debt splurge that preceded it. This despite the fact that this borrowing and spending was supporting an economic structure that could not be sustained...and that the choices of borrowing of the scale needed to support a continuation was becoming impossible. And that is the problem with their solutions, that they can never be proved wrong, as whatever is done, it always necessitates more to be done. If the fiscal stimulus runs out of steam, have another one, and another one, and another one. If it is not working, a larger one will do the trick. If the larger one does not do the trick, then there is an even larger one that might be do the trick. In nobody will lend, print money. If that does not work, just print more.

Their solutions have just been tried, and the result is what we see before us. Massive fiscal stimuli have been tried. Quantitative easing (printing money) to fund government debt has been tried. Despite this, the economic crisis just keeps coming back. The difference now is that we can see where these policies have left the world economy - on the edge of a cliff. They can not claim that the problem is a market failure, as any reasonable economic theory must account for the actuality of markets. That actuality is quite reasonable - the markets think that, if they continue to lend to the major debtor governments, they will not have their money repaid in real terms, or will not be paid due to default. The markets have recognised that there is no clear plan for how the ongoing debt accumulation, and repayment of debt, might be achieved/sustained.

Despite all of the money flooding into the US, the 'safe haven', the doubts about the sustainability of the (neo-) Keynesian approach are mounting. It is only a matter of time before the markets confront the US. With the commencement of fiscal retrenchment elsewhere, and the drive for deeper austerity measures, eventually the markets will turn more cynical eyes upon the US economy. By that time, the US will be even deeper in the quagmire of debt.

I might summarise the position as follows; just as the consumer debt spiralled and unwound, sovereign debt has replaced that debt and must eventually unwind. The nature and the speed of that unwinding is still uncertain. The politicians and policymakers have still yet to fully play their hands, and they will be confronted with resistance from their populations as they seek to win the beauty contest. Set against the governments will be the bond markets, the judges in the beauty (least ugly) competition. Furthermore, in the tangled world of mutual dependency of one economy upon other economies, it is still uncertain where the really weak players in the world economy might be. As the debt accumulation goes into reverse, the dependencies will start to become apparent, and may present some surprising outcomes. However, one thing is certain; whatever the eventual outcome, no country is going to come out of the progressive fiscal consolidation untouched.

Note: I have been planning to discuss the neo-Keynesian approach for a while, but have lacked the time to do the subject justice. I may devote a post to this subject in the future, in particular a response to the volumes of material posted in the comments section by a regular commentator who posts under the name of 'Lord Keynes'. In the meantime, I will leave the discussion as the brief comment above.