Four years after first cracks in the financial system emerged, the coincidence of the euro-area and the US debt crises is a powerful reminder of the complexity of the chain of events set in motion by the global financial crisis. Citizens who were told in 2009 that resolute joint action by the members of the Group of Twenty had avoided the worst are understandably puzzled and wonder what went wrong: Were these crises ineluctable? Did the decision to rely on fiscal stimulus plant the seeds of further troubles? Or was the subsequent fiscal retrenchment too slow?
Economists tend to argue with each-other and blame failure to a colleague or one of these “defunct economists” to whom Keynes famously attributed policy failures. In the European as well as in the US case, there is however a better explanation: it is the politics, rather than the economics of policymaking that is to blame.
Take the euro area first. On the aggregate, its 2011 budgetary deficit is expected to be close to 4 per cent of GDP and its debt-to-GDP ratio to remain below 90 per cent. Not glamorous numbers for sure, but good enough ones to retain easy access to the bond market. And the momentum is toward correction. After the 2009 stimulus discussions about retrenchment started in the autumn already and implementation began for real in 2011. Looking ahead, the debt ratio is likely to remain roughly stable between 2011 and 2012 and there are good reasons to forecast that it will start declining thereafter. At a longer horizon demographics are not great, nor is economic growth buoyant, but again not to the point where the budget equation would look unmanageable. Countries in deep trouble – Greece, Ireland and Portugal – jointly account for 6 per cent of the aggregate GDP of the area, and their combined public debt to 8 per cent of it. Even assuming – a very pessimistic assumption – that half of their debt has to be taken over by their partners, the corresponding cost would be 4 per cent of the euro area GDP only. Hardly a fatal blow.
So why worry? The answer is, because of the politics of the euro area. Throughout the crisis decision-making has been slow, mutual distrust has been pervasive, and reluctance to comprehensive solutions enduring. There are understandable reasons for this situation that essentially boil down to different interpretations of the initial euro contract. But disagreements are commonplace in modern societies and the political processes are made to sort them out. Rather, the EU processes do not provide an avenue for deciding when member states do not agree. This leads to a tendency to postpone and hope for the best instead of taking action. When they eventually agree to a solution – which they have done more often than generally realised – governments tend to be behind the curve and much less effective than they could be. So the politics of the euro is not hopeless, but it is painful enough to explain the financial travails.
Take the US now. With a higher debt ratio and a fiscal deficit more than twice as large as for the euro area, its situation is undoubtedly worse. Furthermore, it has not yet devised a credible retrenchment path and the agreement voted by Congress on August 2nd is far from mapping out a strategy for fiscal sustainability. But the US taxes-to-GDP ratio is about twelve percentage points below that of the euro area, and it is also below historical average. As to federal receipts, they are currently about four percentage points below the level they were at the end of Ronald Reagan’s second term, and personal income taxes alone are four percentage points below their 2000 level. Unlike in, say, Greece, the tax collection system is effective. The growth outlook is also brighter, thanks to demography and innovation. By any reasonable economic standard, this country is solvent.
Yet what the July 2011 budget saga has indicated is that divisions within US society and across political camps are so deep that the prospects of a sensible compromise that would restore sustainability are remote. This is what Standard and Poor’s, the rating agency, has indicated as a major motivation for the downgrade of the US debt. Its statement, according to which “the political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed” is a clear indication that it is in the end a political judgement, rather than an economic judgment, that led to the downgrade.
Similar observations can be made about other parts of the world, including China, whose rebalancing away from investment- and export-led growth is significantly slower than could have been expected on the basis of the economic diagnosis most observers and policymakers could agree on a few years ago. Here again, economic adjustment confronts the political reality of inertia and entrenched interests.
This situation does not bode well for the global rebalancing the G20 has been trying to promote for two years now. As growth in the advanced countries falters, international coordination to deliver the “strong, sustainable and balanced growth” agreed upon at the Pittsburgh summit is more needed than ever. The sad reality, however, is that the spirit of cooperation that made possible to act jointly to ward off the recession has dissipated. Governments everywhere are increasingly determined by the divergent and in some cases paralysing dynamics of domestic politics. Their contribution to the stability of the world economy is becoming a lesser concern.
History in fact is teaching us that contrary to what Keynes wrote, misconception or sheer ignorance were not necessarily at the root of the policy mistakes of the past. In several instances policymakers knew what was desirable but were just not able to deliver it. It would be tragic to go down this route again.
A version of this column was also published by Century Weekly.