By Martin Wolf
Financial Timers, February 16 2010

Niall Ferguson is not given to understatement. So I was not surprised by the claim last week that the US will face a Greek crisis. I promptly dismissed this as hysteria. Like many other high-income countries, the US is indeed walking a fiscal tightrope. But the dangers are excessive looseness in the long run and excessive tightness in the short run. It is a dilemma of which Prof Ferguson seems unaware.

Prof Ferguson stated that, according to the White House projections, gross federal debt will exceed 100 per cent of gross domestic product by 2012; that the US is forecast never to run a balanced budget again; that monetary policy, not deficits, saved the economy; that higher interest rates are on the way; and, not least, that high fiscal debt is damaging.

Brad DeLong of the University of California, Berkeley, responded that parts of this argument are wrong or misleading: White House projections are for federal debt held by the public to be 71 per cent of GDP in 2012 and not to exceed 77 per cent by 2020; monetary policy would not have delivered even the limited recovery we have had on its own; and higher interest rates may indeed be on the way, but there is nothing in current yield curves to suggest it. Moreover, there is no reason to balance budgets in a country whose nominal GDP grows at up to 5 per cent a year in normal times.

Prof Ferguson is trying to frighten US policymakers out of sustaining or, better still, increasing fiscal stimulus, even though the true issue is longer-term sustainability. He also accuses opponents of believing in a “Keynesian free lunch”. Not so. The argument is, rather, that the benefits of the higher output today exceed the costs of debt service tomorrow.

Prof Ferguson believes instead in a conservative free lunch. This is the view that fiscal tightening today would have little effect on activity. Normally, when monetary policy has room for manoeuvre and the private sector’s borrowing is unconstrained, that is right. But, as Olivier Blanchard, chief economist of the International Monetary Fund, and colleagues note in a recent report: “To the extent that monetary policy, including credit and quantitative easing, had largely reached its limits, policymakers had little choice but to rely on fiscal policy.”

The high-income countries that have experienced the biggest jumps in deficits and debts have, inevitably, been Ireland, Spain, the UK and US, as Stephen Cecchetti and colleagues at the Bank for International Settlements pointed out in “The Future of Public Debt”, a paper presented last week at a conference celebrating the 75th birthday of the Reserve Bank of India. These are the countries that had the biggest credit booms and asset bubbles. It is there, as a result, that private-sector spending has been most constrained by the pressure to deleverage.

Jumps in fiscal deficits are the mirror image of retrenchment by battered private sectors. In the US, the financial balance of the private sector (the gap between income and expenditure) shifted from minus 2.1 per cent of GDP in the fourth quarter of 2007 to plus 6.7 per cent in the third quarter of 2009, a swing of 8.8 per cent of GDP (see chart). This massive swing occurred despite the Federal Reserve’s efforts to sustain lending and spending. Similar shifts occurred in other crisis-hit countries.

If these governments had decided to balance their budgets, as many conservatives demand, two possible outcomes can be envisaged: the plausible one is that we would now be in the Great Depression redux; the fanciful one is that, despite huge increases in taxation or vast cuts in spending, the private sector would have borrowed and spent as if no crisis at all had happened. In other words, a massive fiscal tightening would actually expand the economy. This is to believe in magic.

The huge increases in fiscal deficits were appropriate to the circumstances. The only way to have avoided them would have been to prevent prior expansions of private credit and debt. But Prof Ferguson is right: everybody knows that such deficits cannot continue indefinitely. As Carmen Reinhart and Kenneth Rogoff point out in a recent paper, once ratios of public debt to GDP exceed 90 per cent, median growth rates fall by 1 per cent a year. That would be costly. Moreover, there is a risk that, at some point, confidence would be lost and interest rates would soar, with dire impact on debt dynamics.

The difficulty, however, is that, as the McKinsey Global Institute has also noted in a recent report: “Historic deleveraging episodes have been painful, on average lasting six to seven years and reducing the ratio of debt to GDP by 25 per cent”. The only ways to accelerate this would be via mass bankruptcy or inflation. If these are ruled out, what might support demand, while deleveraging continued? If fiscal policy is also ruled out, the only option would be foreign demand. But who is likely to offset contracting demand in the US and other hard-hit economies? Nobody, alas, is the answer.

Yet, as the BIS paper also noted, long-run fiscal prospects, largely driven by ageing, are dire. Projecting forward from the dreadful starting points, the BIS authors argue that ratios of public debt to GDP could reach 250 per cent of GDP in Italy by 2050, 300 per cent in Germany, 400 per cent in France, 450 per cent in the US, 500 per cent in the UK and 600 per cent in Japan. If the sovereign debts of high-income countries are not to be reduced to junk, these countries do indeed need credible plans for retrenchment. On this there is no disagreement. The best approach would be sharp reductions in long-term growth of entitlement spending. Furthermore, as economies recover, short-term fiscal action will be needed. Actions will have to include spending cuts and increases in tax, to restore revenue lost forever in the crisis.

Now we come to the big dilemma: what if private deleveraging and fiscal deficits continue in the US and elsewhere for years, as they did in Japan? Then triple A-rated countries, including even the US, might lose all fiscal headroom. This has not yet happened to Japan. It might well not happen to the US. But it could.