Buiter: no politically feasible route to sustained growth for many years to come
In the aftermath of the emergence of a “reinforced ‘Stability and Growth Pact’”, Citigroup chief economist Willem Buiter is pessimistic about growth outcomes in the major developed economies because the political economy of the sovereign debt crisis will stymie any pro-growth policy solutions. While Buiter sees giving the ECB a green light to monetise euro area government debt as the genesis of the deal, he anticipates years (or decades) of low growth and he warns that ECB policy support will neither be “open-ended” or “unconditional” (hat tip Scott). On a positive front, Buiter says it “should allay concerns about disorderly sovereign defaults by Italy or Spain and about euro area break-up.”
Buiter wrote in a note yesterday:
There really is no politically feasible route back to sustained economic growth through monetary and/or demand stimulating policies for the EA, the UK, the US and Japan, for many years to come. As regards demand stimulus, expansionary fiscal policy will not be punished by the markets to the point of being self-defeating for all EA member states except for Germany (which will not do it on any significant scale for domestic political reasons). The US also may be technically able to use fiscal expansion to stimulate demand, but even if markets continue to be tolerant, political gridlock makes it impossible. Expansionary monetary policy is at the end of its rope in the US and Japan. The UK could cut the official policy rate by 50 bps and the ECB by 125 bps, and then they too are restricted to quantitative easing (QE), which I consider to be ineffective.
Helicopter money (cash transfers to households funded permanently by the central bank) would be expansionary for the Periphery, the EA soft core, Japan, the US and probably also for the UK (depending on your view of how much slack there is in the UK economy). Helicopter money is, however, politically infeasible in the EA, Japan and the US. In the UK Mervyn King might have a go.
A recovery of global demand would help, but is not a policy instrument of the EA or anyone else. The exchange rate is not a separate instrument, but the reflection of relatively loose current and anticipated future monetary policy. Most exchange rate movements are inexplicable even ex-post. The exchange rate, to the extent that it is an instrument at all, is one only for the EA as a whole. The larger the area that is looking for a stimulus to demand (the industrial countries are just under 60 pct of world GDP at market exchange rates), the less effective any exchange rate depreciation is.
Supply side policies (privatisation and structural reform) will raise the level of potential output, and possibly even its growth rate, but are unlikely to give rise to spontaneous animal spirits capable of boosting fixed investment and household demand to utilise that potential.
For the rest, the fiscally unsustainable sovereigns have the choice of further fiscal tightening or default/restructuring. This is true currently in the EA periphery, the EA soft core and in the UK. It will soon be true also for the US and Japan.
I should note that Buiter sees this as a political problem, meaning that fiscal cuts will eventually yield results in terms of cutting budget deficits. The question is whether those cuts are politically sustainable over the medium-term. For example, supply side policies like privatisation will be politically-charged, especially if assets fall into the hands of foreigners.
Continuing, Buiter writes:
There is no evidence that fiscal austerity depresses demand and activity to the point that the government deficit actually fails to improve or indeed increases, i.e. there is no empirical evidence whatsoever for the existence of a Keynesian Laffer curve. So fiscal austerity should work, i.e. it will restore fiscal sustainability despite depressing activity and growth, if it is politically possible to stick to it. Sure, growth would be nice, as would unanticipated inflation, but we are going to get neither until fiscal sustainability has been restored, either through years of fiscal austerity and recession or by restructuring.
While Buiter poo-poos the concept of a “Keynesian Laffer curve” increasing deficits due to demand destruction, it should be clear that a business cycle that tips from recovery to recession is one in which in the short-term, deficits increase. Over the medium-term, the so-called Keynesian Laffer curve is a misnomer because the demand threat is not tied to fiscal policy at all. The demand threat is about debt deflation dynamics, which could emanate from any significant demand shock, particularly large bank insolvencies. The empirical evidence for this certainly comes from the fiscal path in 2009 when bank distress opened up deficits across the developed economies. The same dynamics were at play in the Great Depression and would occur if a large national government defaulted on its sovereign debt. Moreover, because of the risk of credit availability and demand collapsing in countries with the weakest banking systems like Spain, I believe deficits there will increase – at least in the short-term (unless the cuts are deep enough to overcome the negative shock to house prices, bank balance sheets and credit). This is indeed what has happened in Greece when the spectre of national government insolvency caused capital flight and killed credit availability. Irrespective, time will be the arbiter. Moreover, over the medium-term, absent debt deflation dynamics, cuts will yield results if they are politically sustainable. This is a big if.