Friday, September 10, 2004

It's Deficit Time Again

There's a fair amount of talk again this week about the various government deficits and what to do with them. Earlier in the week the FT had a piece about the current state of play with the US deficit whilst the Economist is busy musing one more time over the ongoing saga of the EU growth and stability pact.

These two situations appear, on the surface, to be somewhat similar, but in reality it may be more interesting to consider how they differ.

The problems of the US Federal deficit and its potential implications are by now relatively well known:

Congressional forecasts published on Tuesday suggest that President George W. Bush is on track to miss his pledge to halve the ballooning US budget deficit within five years.

According to the non-partisan Congressional Budget Office, the deficit will fall from this year's 3.6 per cent of national income - a record $422bn - to 2.1 per cent of GDP in five years' time. The CBO's estimate of the cumulative deficit in the decade to 2014 will be $2,294bn.

This five-year outlook assumes no real rises in discretionary spending over the next decade and could be far worse if the president's tax cuts of 2001 and 2003 are extended, as Mr Bush has pledged to do.

Failure to reduce the deficit could lead to higher interest rates in the long term and a decline in the dollar, some economists warn.
Source: Financial Times

The EU 'dilemna' is also hardly 'breaking news':

THE European Union?s stability pact ............died an early, political death, when in November of last year the euro area?s finance ministers refused to punish their French and German colleagues for repeatedly running budget deficits in excess of 3% of GDP. On Friday September 3rd Romano Prodi, outgoing president of the commission, and Joaqu?n Almunia, the EU?s commissioner for monetary affairs, announced their proposals for a reformed pact that will be economically literate and politically feasible, albeit legally feeble.

The commission used to argue, with some justification, that the 3% deficit ceiling gave governments plenty of room to spend their way out of recessions, provided they also saved their way through upswings. Unfortunately, that was not the way the pact worked in practice. Germany, for example, was asked to do too little during its last economic boom (four long years ago), and it is now being asked to do too much in the midst of economic stagnation.
Source: The Economist

Really I don't want to enter too much today into the politics of the US deficit situation. I imagine that is going to get plenty of 'airing' over the next couple of months as the presidential election looms. What I want to draw attention to are the underlying differences between these two situations in terms of the demographic and growth backdrop.

The Washington based Population Reference Bureau hit the headlines in mid August with a report on the global population outlook (PDF) (which despite the coverage really added nothing new to information and data already readily available at the UN population division). Apart from the obvious fact of a projected dramatic global population increase over the next 50 years from 6,000 to 9,000 million (which will clearly have an important influence on the relative pricing of raw material resources like oil), the report drew our attention to the changing distribution of this population, in particular, for our present concerns, to the differences between the US and the other OECD countries.

To illustrate their point the PRB drew attention to two countries with starkly different population projections: Nigeria and Japan. They point out that, today, the two countries have similar populations: 137 million for Nigeria and 128 million for Japan. But by 2050, Nigeria's population is expected to reach 307 million, while Japan's population is projected to decline by 22 percent to 100 million, ie Nigeria will be three times the size of Japan.

The really significant difference, however, are to be found elsewhere. For when it comes to population trends, the United States is in an enviable position relative to its industrialized peers. While Japan and most EU countries have a fertility rate that is well below replacement, the United States still enjoys a steady and sustainable fertility rate of around two births per female. In addition, they note the United States benefits from a regular infusion of working-age people thanks to the 1.3 million immigrants who arrive in the country each year. Against this backdrop U.S. population is expected to swell to more than 400 million by 2050.

So this is the first point: the US, like Europe, is an ageing society, but the population momentum is still much higher. This means that the economic problems faced differ significantly in each case. I have posted at lengh recently about the soft labour market in the US and its attendant problems, but one point needs to be made clearly: the labour market is in part 'soft' since the US demographics are such that it needs to create around 175,000 new jobs every month just to tread water. This is not the European case.

I have been arguing that in fact the US case is far nearer to the UK situation which Keynes struggled to address in the 1920's: growing working age population and declining global importance economically (in this case due to the rise of new powers like China and India, in the earlier UK case due to the arrival of the US itself). Given this it is pretty reasonable to argue that more traditional Keynesian remedies are more relevant to the US, and amongst these policy remedies is of course the fiscal deficit. The EU situation is quite different: we simply don't have this luxury, we are in a more 'backs to the wall' battle.

(Interlude: news in today about the Japanese economy which reveals a significant slowdown in second quater growth indicates what may happen when government expenditure needs to be cut 'at a forced march'. Equally revealing in a European context is the Swiss case (another of the significantly ageing European societies) where again the typical symptom of a domestic demand which stubbornly refuses to revive has seen interest rates near to a Japanese style zero rate policy (ZIRP) for some time now: I don't think it will be going up too far any time soon)).

Now I am not saying that the US deficit, and the manner of inflating it (the Bush tax cut) are not important issues, I am simply saying that this pales virtually into insignificance when compared with the European case. The US has much more room for manoeuvre, that's all.

Reinforcing this is the relative growth situation. UK chancellor of the exchequer Gordon Brown in an interview in the FT today (subscription only unfortunately, although a summary can be found here) gets right to the heart of the matter.

?It is the weakness of European Union growth that lies at the root of imbalances?

What does he have in mind here, well the fact that the Europe economies collectively have grown at a rate of 3 per cent in only one year in the past 10, while the US grew at more than 3 per cent on average over the decade, might do for starters. Clearly the EU economies, and the eurozone in particular, have a 'growth deficiency problem'. And it is this which again makes all the difference with the deficits. For if Europe doesn't get growth, then meeting even the minimum deficit reduction criteria is going to be near impossible.

So what are the proposals?

Basically the new Commission proposals to 'flexibilize' the pact are twofold. In the first place they would oblige countries to tighten fiscal policy in good times, but allow them more leeway to loosen it in bad times. And in the second place the commission wants to shift its focus from the size of a country?s deficit to the sustainability of its debts. In other words towards the proportion of a country's GDP the accumulated (not the annual) deficit represents. Put simply, this would move the key 'sinners' from being France, Germany and the Netherlands - who have the highest deficit forecasts for this year - to Italy, Greece and Belgium all of whom have accumulated debts on or around the 100% of GDP mark.

This second point has a certain logic, since it is difficult to see how these states can sustain their finances if there is not a drastic reduction in the accumulated deficit (which means annual budget surpluses, not deficits!). Regular readers will already know that I have long seen the Italian economy as the real 'sick man of Europe', and as such I can only welcome this emphasis. In fact I see the Italian case as the litmus test for the whole problem. (Indeed I am happy to let my demographic 'thesis' stand or fall on the Italian 'bridge'. Remember Italy is far from being Japan in economic terms. I am not a betting man, but I have no doubt that I would be backing a 'winner' here). But this being said, I am far from being convinced that the new proposal will be sufficient to alter dramatically even the Italian situation.

Going back to the first point - the good times bad times distinction - the problem is that this really begs the question: how do you decide where in the cycle you are, and, indeed, what kind of cycle you are on? In theory, and according to the 'luminaries' aren't we now in full recovery mode? This being the case, oughtn't countries like Germany and France now to be running not deficits but surpluses to get ready for the downswing to come? It is hard in this context to see what all these fine words mean.

So as I said, we are 'backs to the wall'. In this context, and in order not to be simply called a 'defeatist', I will cite the words of the paraplegic Catalan poet Miquel Marti i Pol:

Treure l'espada
Treure el pit
Tot es possible
Tot esta per fer

which liberally translated reads:

Out with the sword
Out with your chest
Everything is possible
Everything is still to do

If this doesn't seem much like a policy then I will leave you with the thoughts of one European politician of an earlier generation, in his blood, toil, tears and sweat speech:

"You ask, what is our policy? I say it is to wage war by land, sea, and air. War with all our might and with all the strength God has given us, and to wage war against a monstrous tyranny never surpassed in the dark and lamentable catalogue of human crime. That is our policy."

Of course I am not thinking here of the kind of war one GWB would have in mind. I am thinking of a war on poverty, injustice, desperation, fatalism. A war which could avoid seeing the majority of the EU elderly population sinking into poverty and depression in the face of problems which seem insurmountable. A war to instill optimism and drive into a generation of young people who - faced with the mounting costs of intergenerational transfers - may sometimes see little alternative to leaving what may seem increasingly like a sinking ship. A war to save the ideals which we all as Europeans can be justifiably proud of. As a child I coudn't stand Churchill for the class bias and priviledge which he seemed to represent. Now I find politicians of his calibre, and economists of the stature and commitment of Keynes, sorely wanting. How one's perspective on things changes with age!