What’s at stake: Discussions about exit strategies from the massive increase in liquidity and budget deficits intensified again in the run-up to the G20 as world leaders set out the first steps toward withdrawing emergency support for the global economy. In the last few days in particular, there has been renewed discussions on the extent of a risk that the financial crisis is slowly morphing into a government debt crisis.
Kenneth Rogoff says that the latest “this time is different” folly is that, because governments are taking all the debts on their shoulders, the rest of us don’t have to worry. For better or for worse, the reason most investors are now much more confident than they were a few months ago is that governments around the world have cast a vast safety net under much of the financial system. Government backstops work because taxpayers have deep pockets, but no pocket is bottomless and there is still thus a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis. The question today is not why no one is warning about the next crisis. The question is whether political leaders are listening. The unwinding of unsustainable government deficit levels is a key question that G20 leaders must ask themselves when they meet in Pittsburgh later this month.
Paul Krugman says if we face a potential problem, it’s not because the economy can’t handle the extra debt. Instead, it’s the politics, stupid. Over the really long term, the U.S. government will have big problems unless it makes some major changes. In particular, it has to rein in the growth of Medicare and Medicaid spending. That shouldn’t be hard though in the context of overall health care reform. After all, America spends far more on health care than other advanced countries, without better results, so we should be able to make our system more cost-efficient. So don’t fret about this year’s deficit; we actually need to run up federal debt right now and need to keep doing it until the economy is on a solid path to recovery. And the extra debt should be manageable. So if we face a potential problem, it’s not because the economy can’t handle the extra debt. Instead, it’s because even the most modest attempts to improve the system are successfully blocked in Congress.
Antonio Fatas says the experience of the European countries in the 90s bring both good and bad news. The good news is that countries can "survive" with very high levels of debt. In fact, we need to realise that the burden that this debt imposed on the Italian or Belgian government budget was substantial because the interest rates were much higher than the rates that governments in advanced economies face today. Even with those high rates, levels of debt above 100% did not lead to insolvency. The bad news is that while we saw over the years that followed a gradual reduction of those levels as a result of increased fiscal discipline and GDP growth, the levels have been coming down at a very low rate. The slope going up seems to be much faster than when it goes down.
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