Cut the Deficits - Now
By Yves Mersch, Governor of the Banque centrale du Luxembourg and member of the Governing Council of the European Central Bank,
Opinion published in The Wall Street Journal Europe, 5.01.2011
Although it is common in medicine to provide strong, inebriating drugs to ease the pain in the case of an emergency, no serious health professional would extend such measures for longer than necessary, given the risks of addiction and long-term damage to vital organs.
In economics, for whatever reason, this seems to be different. The global economy has gone through three years of bold macroeconomic stabilization. But the current attempts to reduce deficit spending and stop governmental ad hoc measures are rather timid. It would be misleading, however, to think we can go on like this for ever. Sooner rather than later, we have to return to a path of stability.
When the financial crisis was feeding through to the real economy, there was no alternative to decisive intervention by governments and central banks. Otherwise, the great financial crisis threatened to degenerate into a recession of the dimensions of the Great Depression some 80 years ago.
Indeed, over roughly one year, the speed and scale of the contraction of global industrial production was very similar to that of the Great Depression. The decline in international trade and several asset prices was even worse. The important dissimilarity was that during the late 1920s the freefall in industrial production continued for three years while in the current recession it came to a halt after 12 months -- a difference policy makers and central bankers clearly deserve considerable credit for.
But macroeconomic policy is far from being omnipotent. Even though a meltdown of the global economy was prevented, the consequences of the financial panic for the real economy were still devastating in many countries. Since the outbreak of the crisis in 2007 some 30 million people have lost their jobs world-wide. According to the International Monetary Fund those G-20 countries that went through a financial crisis experienced a cumulative output loss of about 26% of GDP relative to trend over the past three years.
The fact that monetary and fiscal authorities were too passive some 80 years ago does not mean that prolonged activism will save the day. It would be a mistake to assume that by continuing with bold ad hoc measures the need for adjustment could be circumvented. Those countries that have lived beyond their means will face periods of austerity. Fiscal and monetary tools can prevent a downward spiral in the short term, but they cannot undo the years of profligacy that came before. Nor can fiscal and monetary stimuli replace structural reforms, private investment and innovation -- the true sources of economic growth. Temporarily, stabilization measures might work as a parachute; they will fail, however, as an engine of economic growth in the longer term.
Moreover, the recent massive interventions are not for free. Even though the economies in the industrialized world have not returned to pre-crisis levels of wealth, a daunting legacy weighs already heavy on Western societies, stemming in particular from fiscal policy.
The decline in output made tax revenues drop sharply. At the same time, huge financial rescue programs and large fiscal stimulus packages have inflated government expenditures. This combination challenges the sustainability of public finances in many industrial economies. Public debt-to-GDP ratios in mature markets are projected to rise from 76% in 2007 to more than 100% in 2011 -- a level unprecedented in peacetime.
Prolonged stabilization measures might themselves turn into a source of instability. Even John Maynard Keynes, the godfather of discretionary interventions, was aware of this. After the Great Depression, Keynes acknowledged: "Just as it was advisable for the government to incur debt during the slump, so for the same reasons it is now advisable that they should incline to the opposite policy."
Now the time is near for policy makers to withdraw economic stimulus at a moderate but steady pace. Costly ad hoc measures should be replaced by rule-based, medium- to long-term oriented "Ordnungspolitik." This German expression describes the economic approach in which the state has a limited role, giving leeway to markets. Although it stresses the importance of setting up incentives properly, it abjures discretionary interference with the plans and actions of market participants.
At the current juncture, such a stability-oriented approach goes along with fiscal consolidation. Governments need to bring public finances onto a sustainable track. Rather than timidly reducing budget deficits, governments will have to achieve surpluses in order to erode the massive debt mountains. By doing so, sovereigns can regain trust from the financial markets. Otherwise, a sudden loss in market confidence might occur and lead to sovereign debt crises in yet more countries. To assume that the debt tolerance in industrialized countries is indefinite might turn out to be a fatal error.
For these reasons, 2011 needs to be the first year of a period of new stability rather than the fourth year of macroeconomic stabilization.