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A Different Shade of Political Risk

While many (myself included) were far more concerned with the discourse surrounding the political risk of the government’s microeconomic policy and its treatment of firms and industries, a new variety of political risk has emerged with a thunderous force. This weekend, the deficit hawks took a major step forward towards influencing macroeconomic policy across the globe. Whereas last year the G-20 countries expressed a commitment to fiscal stimulus, this year, that sentiment is muted: “Those countries with serious fiscal challenges need to accelerate the pace of consolidation,” it said. “We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions.”  This is a very troubling development for the global economy and in my opinion, is its primary risk at this point in time.

As Bill Gross astutely observed, “Tougher sovereign budgets produce government worker layoffs, pay cuts, reduced pension benefits and a drag on consumption and the ability of the private sector to accept an attempted hand-off from fiscal authorities. Recession becomes the fait accompli, and the deficit/GDP ratio moves ever higher because of skyrocketing risk premiums and a plunging GDP denominator.  In many cases therefore, it may not be possible for a country to escape a debt crisis by reducing deficits!” [emphasis Gross’]  While conventional wisdom may hold that reducing spending will close a deficit gap, reality has consistently demonstrated that reducing spending ultimately increases deficits.  Aggregate demand is equal to the sum of consumer expenditures + investment + government expenditures +/- the balance of trade (at the same time, ΔAD=ΔC+ΔI+ΔG+ΔBalance of Trade).  A drop in government spending triggers a drop in aggregate demand, which resultingly triggers a further drop in consumption and investment.

Now many would say that “the markets want smaller deficits” and I personally really don’t like that response.  Anyone who claims to know with certainty what markets should already own vast amounts of wealth.  Such a person, who can read through intuition the markets desires, would simply have to be an outstanding investor.  Bill Gross, an outstanding investor and one of the global sovereign debt markets’ largest private sector participants understands the dilemma facing international policy makers today.  He understands the reality that contracting government expenditures will ultimately result in shrinking aggregate demand and end up with debt taking up a higher percentage of GDP.  That’s exactly why this situation is a dilemma.  There will be pain no matter which path is chose and the common sense solution exacerbates the problem rather than alleviates it.

Most troubling is that people who advocate the cutting of deficits as the mechanism to escape this lingering financial crisis are making a conscious preferential choice to deflate, rather than inflate the economy, in many cases without even knowing of the consequences.  Deflationary times are incredibly dangerous.  In a time of deflation, there is less risk in hoarding cash than there is in investing.  Those who hold cash are rewarded with positive returns without even deploying their capital at all.  Investment drops substantially in a deflationary environment. Economies essentially collapse amidst the snowballing rush for cash and absence of consumption and investment.

As everyone knows, we are in a crisis where too much debt is the problem.  In the long-run, inevitably, the global economy needs to decrease its indebtedness as a percentage of GDP.  The deficit hawks and the Keynesians both understand this reality.  The question then begs itself: if too much debt is the problem, how does increasing government debt solve it?  Well the solution to the problem lies first in cleaning up private sector balance sheets.  Our aggregate level of societal indebtedness has not been expanding during this crisis.  Rather, to the contrary, the destruction of dollars in the private sector has consistently outpaced the level of fiscal and monetary expansion.  Despite the aggressive blend of monetary and fiscal policy, our economy has not been inflating as many of the deficit hawks would have predicted/expected.  This is both a good and bad thing.  One the one hand, it means that we are actively implementing the correct remedy, while on the other, it indicates that we are not using quite enough of that remedy.

So all that being said, first and foremost, the aim of policy-makers has been (and should continue to be) to clean up the balance sheets of the private sector.  This alone comes with increasing indebtedness in the public sector.  If we go back to our aggregate demand function above, an increase in government spending can help maintain aggregate demand at its present level by offsetting the increasing savings (or lack of spending) in the private sector.  Once healthy balance sheets are restored in the households and businesses of America, only then should the government look to decrease its deficit with a combination of decreased spending and increased taxation to pay for the previously lax and expansionary tax policy.  It’s far too early to change courses.  This stuff takes time and already has started working, why stop now?  Should we change courses now, we will inevitably be faced with a “lost decade” ala Japan and we will have wasted all of the strong policy decisions made to date.

A brief lead-in to a future post:

One of my primary gripes with the deficit hawks at this point in time is their attack on “entitlement” programs as the means through which to restore fiscal order.  Our country started the 2000s with  a balanced fiscal budget and a healthy outlook.  President Bush then proceeded to cut taxes while leading the country into two wars.  This has not been, nor is it a matter of entitlements increasing our nation’s debt load.  There were very distinct policy decisions made with known consequences and responses.  It is far easier for economists to attempt to take a “neutral” policy stance while attacking entitlements and ignoring past tax cuts and two wars, but unquestionably, the simultaneous wars in Afghanistan (which as of today is our country’s longest war EVER) and Iraq, completely altered our fiscal balance sheet for the worse.  If we want to seriously talk about cutting government spending, there is no more obvious place to start than with questioning our continued involvement in these two wars.  (This entire discussion is a post of its own, but I could not help but starting the thought here…)

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