Fiscal stimulus is by far the most urgent and important issue at tomorrow’s G-20 meeting. Unfortunately, it is also the most contentious, and it seems depressingly unlikely that an agreement will be reached. There is a disturbing lack of consistency in some of the arguments, and a lack of clarity in the debate. Eurozone countries are still reluctant to step up fiscal stimulus, and are relying largely on automatic stabilizers (see chart). They are censoring the US and UK for trying to spend their way out of this crisis, yet rely on them to provide an export-driven recovery. G-20 leaders must agree on a realistic redistribution of fiscal effort to stimulate a recovery while avoiding a recurrence of macroeconomic imbalances. If they fail to do so, market sentiment will be the first victim: the recent recovery in risk appetite will prove short-lived, and the current bear market rally could end quite quickly. More dangerous still, market concerns about rising public debt in the US and the UK might be exacerbated, hindering central banks’ efforts to lower longer-term yields and triggering higher volatility in FX markets.
DISCRETIONARY VS. AUTOMATIC
Global macroeconomic imbalances, namely the combination of large current account deficits in countries like the US and large current account surpluses in countries like China and Germany have helped set the stage for the current crisis. In turn, these imbalances reflected excessive debt-fueled private spending in the deficit countries, and symmetrically excessive savings in the surplus countries.
As I have argued on the Wall Street Journal Europe today, G-20 leaders must ensure that these imbalances do not recur. But this will require a much greater degree of agreement and coordination on fiscal issues.
To avoid a global depression, governments will need to spend more than they are doing now. The forecasts of all international organizations, including the IMF and most recently the OECD, indicate that the contraction in advanced economies’ GDP in 2009 will be so severe as to trigger a moderate contraction in global GDP, overwhelming the resilience of emerging markets. And the best we can hope for in 2010 seems to be stagnation. This is a clear and powerful argument in favor of further fiscal stimulus. Being worried about inflation at this stage is absurd: a prolonged recession will gradually widen output gaps enough to make deflation a very concrete risk, especially in Europe.
EU countries, and Germany in particular, argue strongly against additional stimulus, warning that excessive spending and widening fiscal deficits will only sow the seeds of future crises. Furthermore, Germany insists it is determined to stick to its export-driven growth strategy, therefore waiting for a recovery in global trade rather than providing additional stimulus to domestic demand. As a result, as the chart on the front page illustrates, EU governments are poised to provide a significantly smaller fiscal expansion than the US. The US stimulus numbers include the substantial support that is being channeled via the financial sector, notably Fannie and Freddie. Moreover, as the chart shows, by far the largest share of European fiscal expansion comes from automatic stabilizers, namely a decline in tax revenues and increases in unemployment compensation and other social benefits. These account for virtually the entire fiscal easing in Italy, 2/3 in Germany and ¾ for the eurozone as a whole.
European governments have correspondingly argued that through the role of stabilizers, fiscal easing is automatically built in, reducing the need for discretionary stimulus. I am not convinced. Automatic stabilizers work largely via a reduction in tax revenues—we estimate that foregone revenues account for 90% of automatic stabilizers in France and the UK, as much as 95% in Italy, while in Germany social benefits play a more important role. But a reduction in tax revenues triggered in large part by lost jobs and incomes and by corporate defaults does very little to help a recovery.
The bottom line is that European countries are still focused on limiting the deterioration of their fiscal accounts, while the US are poised for a much more significant widening of fiscal deficits, which we project will be in double digits in 2009 and 2010 (see chart below).
A SHARP BUDGETARY DETERIORATION
European countries publicly condemn such profligacy, but they privately welcome it, because they realize it could provide the easiest way out of the recession for their economies. Paradoxically, Germany should in fact exhort the US to spend a lot more if it is really counting on an export-led recovery. German exports, which accounted for over 50% of German growth in 2007, have collapsed, and will not recover without a meaningful resumption of economic activity in the US.
GERMAN EXPORTS IN FREEFALL
It should be made extremely clear that the alternative to a substantial boost in global spending is a much longer recession. And it should be made equally clear that unless spending can be rebalanced across countries, global growth will inevitably be much weaker for years to come. The large rise in fiscal deficit is an important concern, which should be addressed by G-20 leaders through a credible commitment to fiscal retrenchment once the recovery begins to materialize. But we first need to create the conditions for a sustainable recovery.
