If we are to understand where we are, we must understand where we have been. This is particularly true if we are to escape from the huge fiscal deficits being run by many governments. These deficits are not the result of government stupidity; they are mainly a consequence of – and response to – private behaviour. We must not ignore this connection.
The difference between domestic savings and investment equals the current account of the balance of payments (itself the inverse of the capital account). Domestic savings and investment can be divided, in turn, between private sector and government. Private, government and foreign balances must sum to zero. But it is still possible to ask how they do so and, in particular, what behaviour drives the specific patterns and levels of activity we see. In the present crisis, asking that question is particularly revealing.
In the chart, I have looked at the principal high-income countries. To these I have added Spain and Ireland, since the “great credit bubble” of the 2000s affected both countries so deeply. I start with 2006, the year before the crisis began. In that year, two external surplus countries – Germany and Japan – were running private sector surpluses of close to 8 per cent of gross domestic product. The French private sector had a small surplus, as did Italy’s. The UK, US, Ireland and Spain ran large private deficits, the last two being gigantic.
In Japan and Germany, part of the private surplus financed government deficits, while part went as a capital outflow abroad. The latter point was particularly true for Germany. In France, the surplus almost entirely financed the government. In the UK and US, a sizeable foreign capital inflow financed both private and fiscal deficits. Meanwhile, in Ireland and Spain the private deficits were partly offset by what seemed to be strong fiscal positions – an illusion, it turned out. But, again, a large part of the finance came from abroad.
Fast forward to the latest forecasts for crisis-hit 2009. Everybody has become German! The private sectors of every country are in massive surplus. Falling asset prices, a broken financial system and tumbling output have driven private savings up and investment down. The surpluses of the US, UK and Irish private sectors are forecast at close to 10 per cent of GDP, which is even higher than in Germany. The private sectors of the US, UK and Ireland are now providing nearly all the savings needed to cover their huge domestic fiscal deficits. Meanwhile, external balances have been sticky, as one would expect during a world recession.
It is when we look at the changes between 2006 and 2009 that their scale becomes clear. The shifts in the balances between private income and spending (or savings and investment), as a share of GDP, are close to 17 per cent of GDP in Spain and Ireland, 14 per cent in the US and 10 per cent in the UK. The shifts in the private sector balances in the non-bubble countries – Japan, France, Italy and Germany – are quite small, however. Indeed, Germany even has a shift towards a smaller surplus. The current account deficits of the post-bubble countries have all diminished a bit. But the predominant offset to changes in their private sector balances was in the government’s finances. As the private sector shifted massively into surplus, the government shifted massively into deficit. In Germany, however, the deterioration in the fiscal balance is entirely an offset to a smaller current account surplus. Japan, France and Italy fall in between the post-bubble countries and the German experience.
What explains what we see? Some believe that the shifts in private sector balances in post-bubble countries are caused by fiscal deficits, either because of “Ricardian equivalence” – the view that people increase savings in response to the higher deficits – or because of “crowding out” of spending by the deficits. Neither of these arguments is even close to persuasive.
On the first point, as a report from the International Monetary Fund, out on Tuesday, shows, not much of the huge rise in fiscal deficits was the result of deliberate stimulus. It was mostly the result of unanticipated structural fiscal deteriorations or the cycle. Again, real interest rates – as shown by index-linked government bonds – are very low (1.4 per cent in the US and below 1 per cent in the UK). This is incompatible with crowding out.
In other words, the deterioration in the fiscal position is a result of the cutback in the private sector’s spending, not a cause of it. Not surprisingly, the fiscal deterioration is also biggest where the private sector has cut back most: in the post-bubble economies.
Of course, governments could have tried to tighten fiscal positions in the teeth of the crisis. All that would have done is turn the recession into a depression. As a result, they would also have transformed part of the structural fiscal deficit into a cyclical one. This might well have lowered the private sector surplus, but only by destroying private income even faster than spending. This would have been a monstrous blunder. In a world in which the private sector is driven towards austerity, as now, governments must offset this behaviour, not reinforce it.
So what are the ways back to fiscal health, particularly in the countries with the biggest deficits? The answers stare at us from the charts: there must be some combination of a recovery in domestic private sector spending with a surge in net exports (and so a fall in the net capital inflow). If the recovery came overwhelmingly from the former, we would see a return to earlier private deficits. But that would almost certainly mean another surge in leverage. This then would be a case of adjustment postponed and, worse, of new bubbles. Alternatively, there could be a surge in net exports. But this also implies increased spending, relative to income, elsewhere. Many fear that this, too, might mean new bubbles.
The fundamental point, however, is that it is idiotic to discuss the reduction of the huge fiscal deficits, without considering the nature of the offsetting adjustments in the private and external sectors. Some adjustments would be desirable, but others would be extremely perilous.
Remember the aim: it is to reach a healthy fiscal position, at high levels of output and with sustainable levels of private spending and external balances. It is a combination many countries signally failed to achieve in the run up to this huge crisis. I see little evidence, hitherto, that we will do very much better on the way out.