Anti-Keynesians and falling commodity prices

June 8, 2010

Policymakers’ new enthusiasm for cutting budget deficits will slow growth across the advanced industrial economies, cutting the outlook for commodity consumption and prices over the next 2-3 years.

For the past year, investors and commentators have been trying to guess how quickly extraordinary stimulus provided during the 2008-2009 crisis would be withdrawn.

Most attention focused on the timing of interest rate increases and measures to mop up excess liquidity provided by central banks. Instead tightening is set to commence from the fiscal side.

Until recently, most commentators saw government spending as part of the solution, and worried about withdrawing fiscal stimulus too quickly, risking a double dip recession. Now deficit spending is seen as the problem, risking a financing crisis. Keynes is once again unfashionable and the bond market vigilantes are in the ascendant.


Governments in Germany, Portugal, Spain, Italy, Greece and Ireland have already outlined austerity measures, while the United Kingdom and France have also promised unspecified efforts to cut deficits and restore public finances.

OECD Secretary-General Angel Gurria has endorsed the approach, albeit with phased implementation. At a conference in Montreal this week, he urged policymakers “Make sure you give signals to the markets about fiscal consolidation.” But he suggested delaying implementation. “Do we have to start now? No. Do we have to announce now? Yes.”.

Gurria’s choice of venue was no accident. Canada’s fiscal consolidation in the 1990s and the fact it escaped mostly unharmed from the financial crisis has made it a world authority of sensible fiscal policy (though it may have had more to do with the country’s strong financial regulation, lack of big investment banks and benefits from being a commodity exporter).

A steady stream of policymakers, including Britain’s new Conservative-Liberal administration, is beating a path to Ottawa for advice on how to manage something similar.


There are plenty of reasons to be sceptical about this new enthusiasm for hair-shirt austerity measures. The argument for fiscal austerity right now is not intellectually coherent:

(1) Much has been made of the danger of a buyers’ strike among government bond investors unless European governments make an early start cutting deficits and outline a credible glide-path for reducing them over the medium term.

Buyers’ strikes can pick off isolated countries. But it is less clear a buyers’ against European government debt en masse is a real threat. What other assets would they shift into?

Neither corporate debt nor equities look attractive (and would look even less attractive in the midst of a debt crisis). U.S. government bonds are expensive. Emerging market assets look more interesting but are hard for investors to access. China’s government bonds, for example, are not available for purchase.

Government paper remains almost the only choice for investors seeking safety, and will likely remain so unless there is a catastrophic rise in inflation.

(2) While European governments are under pressure to swing the axe quickly, no such pressure is evident in the U.S. bond market, where yields have tightened in recent weeks.

Projections by the non-partisan Congressional Budget Office (CBO) show the federal government running a budget deficit equivalent to 10.3 percent of GDP in fiscal 2010, narrowing to 5.8 percent in fiscal 2012 and hovering around 5 percent through the end of the decade.

But almost all the forecast improvement in the next two years comes from the revenue side (up $690 billion) rather than cuts in spending (which is set to increase by $104 billion on the president’s budget proposals).

A double standard is operating. While the United States hopes to grow its way out of deficits, European governments are under pressure to cut their way out.

(3) There is little or no connection between deficits and debts on the one hand and government bond yields on the other. In theory, deficit reduction should cut yields, while anything which worsens the deficit should raise borrowing costs. In practice, there is no evidence of a direct link. Too many other variables affect borrowing costs.

The Clinton administration’s deficit-reduction programme in the mid-1990s did coincide with a reduction in long-term bond yields, and that was its intended purpose, according to Robert Woodward’s inside account “The Agenda.” But the massive turnaround in federal finances from surpluses to deficits as a result of the Bush administration’s tax cuts does not appear to have resulted in a significant increase in borrowing costs.

(4) The main risk with rapid deficit reduction is that will push European economies back towards the brink of recession. In time, private sector businesses should take up the slack created by public sector retrenchment, and might on average make productive use of resources. But enthusiasts for retrenchment ignore the delays involved in redeploying resources and jobs, and the real costs during the transition.

Experience suggests adjustments could take 3-5 years or more to complete. Even then the costs could be immense. Employees “released” by the public sector may not have the same skills needed by the private sector.

Meanwhile unemployment will probably rise and consumer spending fall further, threatening investment with it, as firms become more cautious. If unemployment rises, default rates on all those securitised mortgages and commercial loans will start to increase, stepping up the pressure on the financial sector.

(5) Policymakers have spent the last three years struggling to sustain aggregate demand and avoid a deep depression. Deficit-cutters have yet to identify the demand that will replace the lost government spending, jobs and tax rises.

Proponents argue the private sector is waiting in the wings with a plethora of (productive) investment ideas if only the government would step out of the way. But the evidence of the past decade suggests that is a fantasy. Most private investment was spent on residential and commercial real estate, as well as financial re-engineering of existing companies.

European countries could seek to boost their exports. This would have to be Asia (since the United States is seeking to cut its import bill and raise exports itself). Euro devaluation will help. But the most successful exporter, Germany, already finds itself bracketed with China, criticised for relying too heavily on exports rather than domestic demand. Is it really a good idea at this stage for the euro-zone to commence a domestic demand reduction programme?

(6) The biggest problem is timing. OECD governments got themselves into the current mess because they operated a pro-cyclical fiscal policy, misinterpreting a cyclical improvement in revenues and reduction in welfare spending for a structural one, and allowing fiscal discipline to slip. But it would be folly to compound the error by implementing pro-cyclical fiscal tightening when the economy is still in the early stages of recovery.

The best analogy is with banking. There is a consensus banks must hold bigger capital cushions to prevent a repeat of the crisis. It is coupled with a widespread understanding the middle of a recession, when lending is already sluggish, is not the right time to implement big increases in capital requirements, or risk restricting credit even further.

Precisely the same arguments apply to fiscal policy. Governments need to tighten the underlying fiscal position, but when the economy is strong, not when it is weak.

There is a suspicion the newfound fashion for austerity will turn out to be more rhetoric than reality, with cuts promised in future rather than today, easily rescinded when the time comes and expansion boosts government revenues (more pro-cyclicality).

But to the extent cuts are real they will dampen the growth outlook in Europe and globally over the next couple of years. Falls in equity and commodity markets over recent weeks suggest investors are already beginning to incorporate that possibility.

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