Fiat Justitia, et Pereat Mundus

Martin Wolf writes for the London Financial Times via the Business Spectator.

Utopian dreams destroyed by debt

In the eurozone, the fiscal crisis is lapping on Italy’s shores. In the US, the administration declares it will run out of funding early next month if the debt ceiling is not raised. Far fewer Europeans than Americans believe public sector defaults are beneficial. But important Europeans share with Republicans the view that there are still worse outcomes. For reluctant Europeans, the eurozone must not be a ‘transfer union’. For recalcitrant Republicans, taxes must not be raised. Fiat justitia, et pereat mundus – let right be done even if the world perishes – is the motto
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The fiscal crises we see are a legacy of the west’s private and public sector debt binges of recent decades. As the McKinsey Global Institute tells us in an update of last year’s study of the aftermath of the credit bubble, this is an early stage of a painful process of deleveraging in several economies (See: chart). “If history is a guide,” noted the 2010 report, “we would expect many years of debt reduction in specific sectors of some of the world’s largest economies, and this process will exert a significant drag on GDP growth.” So it is proving, with disappointment almost everywhere.

The link between private and public sector debt is intimate. In some countries, notably Greece, easy credit led to an upsurge in public sector borrowing. In others, notably Italy, it encouraged governments to relax attention to debt reduction: its primary fiscal budget (before interest) moved from a surplus of 6 per cent of gross domestic product in 1997, before joining the currency union, to 0.6 per cent in 2005. Elsewhere, the sudden end of private sector credit booms led directly to collapses in government revenue and surges in public spending: the US, UK, Spain and Ireland are examples.
 
Exploding fiscal deficits are mainly the result of collapses in activity and revenue rather than of bank bailouts. But fiscal weakness then undermines the banks, partly because the latter hold large quantities of domestic public debt and partly because they rely on fiscal support. The private and public sectors are intertwined. The view of Republican hawks in the US and of German or Dutch hawks in Europe that the crisis has fiscal roots alone is wrong. Easy credit ends up in fiscal crises. (take note Australia!)

US evidence is striking. Compare the forecasts for fiscal years 2010, 2011 and 2012 in the 2008 and 2012 presidential budgets, the first under George W Bush shortly before the crisis and the second under Barack Obama well after it (see: chart above). The 2011 deficit was forecast in 2008 to be a mere $54 billion (0.3 per cent of GDP). But in the 2012 budget, it is forecast to be $1,645 billion (10.9 per cent of GDP). In all, 58 per cent of this rise is due to unexpectedly low revenue and only 42 per cent due to a surge in spending, both of these changes mostly due to the financial crisis, not the modest stimulus package (about 6 per cent of GDP).
 
The astonishing feature of the federal fiscal position is that revenues are forecast to be a mere 14.4 per cent of GDP in 2011, far below their postwar average of close to 18 per cent. Individual income tax is forecast to be only 6.3 per cent of GDP in 2011. This non-American cannot understand what the fuss is about: in 1988, at the end of Ronald Reagan’s term, receipts were 18.2 per cent of GDP. Tax revenue has to rise substantially if the deficit is to close.
 
It is not that tackling the US fiscal position is urgent. At a time of private sector deleveraging, it is helpful. The US is able to borrow on easy terms, with yields on 10-year bonds close to 3 per cent, as the few non-hysterics predicted. The fiscal challenge is long-term, not immediate. A decision not to allow the government to borrow to finance the programs Congress has already mandated would be insane. As the fiscal expert, Bruce Bartlett, has argued, the law requiring Congressional approval of extra debt might even be unconstitutional.

Yet, astonishingly, many of the Republicans opposed to raising the US debt ceiling do not merely wish to curb federal spending: they enthusiastically desire a default. Either they have no idea how profound the shock would be to their country’s economy and society of a repudiation of debt legally contracted by their state, or they fall into the category of utopian revolutionaries, heedless of all consequences. Meanwhile in Europe, happily, nobody believes that defaults are good. But Europe is trapped in its own utopian project: the single currency. Just as members of the Tea Party hate paying taxes for those they deem unworthy, so, too, do solvent Europeans hate transfers to those they deem irresponsible.
 
Alas, as many have long predicted, what would, in the absence of the currency union, have been a straightforward currency crisis has now morphed, within these constraints, into an agonising fiscal cum financial crisis. Worse, spreads on Spanish and Italian 10-year bonds over German bunds have reached 328 and 296 basis points, respectively.
 
In slow-growing economies with overvalued real exchange rates, these spreads begin to be dangerous. If they became and remained, say, 400 basis points, the real interest rate on long-term debt would be 5 per cent. These countries would then be slowly shifted from a good equilibrium, with manageable debt, to a bad equilibrium, with close to unmanageable debt. Italy, with the fourth-largest public debt in the world, is probably too big to save: Italians themselves must make the decisive moves needed to restore fiscal credibility. That, in turn, requires both a sharp tightening and measures to raise the growth rate. Can this combination be managed? Only with difficulty, is the answer.

These are dangerous times. The US may be on the verge of making among the biggest and least-necessary financial mistakes in world history. The eurozone might be on the verge of a fiscal cum financial crisis that destroys not just the solvency of important countries but even the currency union and, at worst, much of the European project. These times require wisdom and courage among those in charge of our affairs. In the US, utopians of the right are seeking to smash the state that emerged from the 1930s and World War 2. In Europe, politicians are dealing with the legacy of a utopian project which requires a degree of solidarity that their peoples do not feel. How will these clashes between utopia and reality end? In late August, when I return from my break, we may know at least some of the answers.