Monthly Archives: February 2012

Ben Bernanke has been assailed from all sides in the economic debate in recent times. Perhaps that happens to all Fed Chairmen (except, remarkably, to Alan Greenspan, whom almost no-one criticised while he was in office). But in Chairman Bernanke’s case, the criticism has been strident, reflecting the polarisation of views on economic policy in general. 

The political and economic debate on fiscal policy has become increasingly polarised in many countries, and as a result seems to have reached a dead end. Some economists are so concerned about the present rapid rise in government debt that they favour immediate fiscal tightening. Others are so concerned about the risk of renewed recession, and are so unconcerned about the risks from extra public debt, that they demand immediate fiscal easing on a large scale.

In many economies, this debate has now reached a stand-off, in which governments are trying to reduce deficits and debt only very gradually, while hoping that a recovery in private expenditure will keep the economy out of recession. The result, which satisfies nobody, is very slow GDP growth and a continuing rise in public debt ratios. 

A large and important change is underway in global economic policy. This change will determine whether the developed economies can grow their way out of recession. Although the new strategy has been tried before by individual economies, this is the first time it has been adopted on such a global scale. If it fails, it is far from clear that policy-makers have a ready-made alternative plan waiting in the wings. 

Talks in the eurozone about the intended €130bn bail-out package by the EU and IMF have become more convoluted than ever this week. The latest deadline for a final decision by the eurozone is now said to be Monday, and there is no certainty that the deal will be ratified even then.

However, assuming that the Germans, Dutch and Finns are willing to sanction the deal, which on balance seems likely, the package will produce a further large increase in the exposure of eurozone taxpayers to Greece, without reducing the overall burden of Greek indebtedness very much at all.

The deal would therefore involve a further big step towards the “socialisation” of Greek debt to other eurozone sovereigns, while reducing the exposure of the private sector to any further Greek default. From now on, the burden of Greek debt will either by borne by Greek taxpayers, or by eurozone/IMF taxpayers, depending on whether additional defaults occur in future. It will be a simple head-to-head between sovereign governments, which is why the debate is becoming so heated. 

The Greek Parliament votes tonight on the latest austerity package, which Prime Minister Papademos says is essential if the nation is to avoid default, departure from the eurozone and economic chaos. If the motion fails, then markets will need to contemplate whether the euro can survive the contagion which would be caused by disorderly default on Greek debt.

In the more likely event that the motion is passed, and other political conditions are met, then the eurozone group of finance ministers is likely to approve the package on Wednesday. The second official bail-out of €130 billion would then go ahead, subject only to final agreement on private sector involvement (PSI) for debt write-downs of  €100 billion.

Since agreement on PSI is also likely, the bail-out funds should flow before Greece needs to redeem €14 billion of government bonds which fall due on 20 March. Where does this leave Greece, and what are the lessons of the Greek deal for the rest of the eurozone? 

The Bank of England meets on Thursday with expectations running high that the MPC will announce a further large dose of quantitative easing. Even if they pass this month, which seems possible, this is likely to be only a temporary postponement. Whenever it comes, the next move will be another bout of “plain vanilla” QE, involving the purchase of £50-75bn of government bonds, and taking the overall Bank of England holdings to over one third of the total stock of gilts in issue.

Meanwhile, the Fed is still debating whether to increase its holdings of long dated securities, and if so whether to focus once again on government debt, or to re-open its purchases of mortgages. Any further QE would be contentious on the FOMC, but there is probably still a majority in favour.

Central bankers, unlike many others, have not lost faith in the efficacy of QE. The vast majority of them not only believe that additional asset purchases can further reduce long term bond yields at a time of zero short term interest rates, but also that this can increase real GDP growth, compared with what otherwise would have occurred. Are they right? 

The debate on the correct setting for fiscal policy at a time of recession is probably the oldest debate in macro-economics. One key element in the debate is the trade off between supporting output growth in the short term, versus the need to control the growth of public debt in the long term.

There are some economists who do not recognise that this trade off exists at all, because they claim that an increase in the fiscal deficit cannot impact aggregate demand, even in the short run. But this is not a view which I believe to be supported either by empirical research or by economic theory (except on some very restrictive assumptions about Ricardian Equivalence or Says Law).

I recognise that this last statement is very contentious, but it is not my subject today. Instead, I would like to take as given the assumption that a temporary easing in fiscal policy (of the type advocated last week by Martin Wolf for the UK) will increase aggregate demand in the near term. Accepting this, I would then like to ask whether the benefits of an immediate boost to aggregate demand outweigh the costs of higher public debt, and the consequent risks of a fiscal crisis. That is the nub of the issue which is, or should be, exercising policy-makers in the real world today.