The New Phase of the Crisis

The Great Recession was followed by an anaemic recovery in the advanced economies, which threatens to be followed by a double dip or worse now that the fiscal stimulus measures of 2009 and 2010 have been succeeded by austerity programs.

Now we face a new financial crisis, or at least a stock market correction of major proportions, which may precipitate a new phase of the crisis.

The financial markets seem to suffer from acute schizophrenia, with the bond markets demanding more fiscal austerity in much of the Euro zone, while stock markets are panicking at clear signs of slowing US and global growth.

How should governments be responding to the panic in the markets?

Not, as they have, by caving in to the bond markets.

The G7 Statement issued on Sunday called for increased “fiscal discipline” and welcomed the intensifying Spanish and Italian austerity programs. It also ruled out demands on private sector bondholders to take any further haircuts on government debt, beyond the recent actions taken with respect to rolling over Greek debt .

The statement also welcomed the recent US debt deal, which implies more – perhaps significantly more – spending cuts in the near future and certainly means no new stimulus to support a very weak economy stuck with very high unemployment.

There are obscure hints about intervening in the financial markets, but support for market-determined exchange rates was reaffirmed.

What, then, should governments be doing?

The message that seems to come through most of the media – including today’s Globe – is that governments really can’t do very much because they are stuck between a rock and a hard place. Temporary stimulus measures secured a temporary recovery, but at the cost of precipitating an unsustainable increase in public sector debt which now has to be unwound. That is likely to mean a very slow recovery or even worse, but further stimulus would make the underlying problem even worse. Hence we just have to reconcile ourselves to tough times.

This narrative is hard to confront, even though it has serious flaws.

As Krugman, Stiglitz, Dean Baker and many others argue, there is no huge fiscal problem in the US, and certainly no real prospect of a US debt default given that the US Federal Reserve can always finance US government debt. US government bond yields are at record lows. The real US problem is totally dysfunctional politics. In the short-term, the US needs but will not get a new stimulus program. Over the medium-term, US government deficits and debts could be reduced by sensible health care reform and by raising taxes to levels approximating those in other advanced economies.

In the Euro area as a whole, the debt problem is worse but there is no huge and immediate fiscal problem. Growth could be maintained if the stronger economies, notably Germany and the smaller northern economies, were prepared to expand government spending and private consumption enough to boost growth in the PIIGS, and to allow for a fall in their trade surpluses so that the weaker economies might be able to export more. Euro areas institutions need to be changed so that the European Central Bank can effectively backstop Euro government debt and help governments to lower borrowing costs for those countries which do face serious fiscal problems.

Sunday’s decision by the European Central Bank to purchase big Euro economy bonds seems to be temporarily working to reduce Euro bond spreads, but looks like another quick fix. The underlying issue seems to be that the cost of refinancing high interest sovereign debt at lower rates would be high,and a political non starter for the “virtuous” Euro economies like Germany which can borrow at much lower rates than Spain and Italy. The dominant approach is still to insist on greater austerity in countries with high deficits and/or debt, while ruling out “haircuts” for the bondholders out of fear of sinking big European banks

The key problem, then, is that the policy shifts we need seem to be political non starters. Which is why the G7 focus remains very much on austerity. Which will make things worse. Which is why the stock markets are panicking. Which will, in turn, make things even worse.

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