On a number of occasions I have cautioned against deficit-financed fiscal stimuli in countries whose governments have weak fiscal credibility, that is, countries where current tax cuts or public spending increases cannot be credibly matched by commitments to future public spending cuts and tax increases of equal present discounted value.  I believe that both the US and the UK fall into this category.

I have spent a good part of my career as a professional economist working on developing countries and emerging markets – in South America, in Central and Eastern Europe and the former Soviet Union and in Asia.  Increasingly, I find it helpful to analyse the crises afflicting the US and the UK as emerging market crises – perhaps they could be called submerging markets crises.

During the decade leading up to the crisis, current account deficits increased steadily and became unsustainable.  Strong domestic investment (much of it in unproductive residential construction) outstripped domestic saving. Government budget discipline dissipated; fiscal policy became pro-cyclical.  Financial regulation and supervision was weak to non-existent, encouraging credit and asset price booms and bubbles.  Corporate governance, especially but not only in the banking sector, became increasingly subservient to the interests of the CEOs and the other top managers.

There was a steady erosion in business ethics and moral standards in commerce and trade.  Regulatory capture and corruption, from petty corruption to grand corruption to state capture, became common place.  Truth-telling and trust became increasingly scarce commodities in politics and in business life.  The choice between telling the truth (the whole truth and nothing but the truth)  and telling a deliberate lie or half-truth became a tactical option.  Combined with increasing myopia, this meant that even reputational considerations no longer acted as a constraint on deliberate deception and the use of lies as a policy instrument.

The German federal minister of finance, Peer Steinbrueck, does not like anything that increases government deficits.  He does not like them, Sam-I-Am.  I believe he is wrong – very wrong and dangerously wrong. In the interest of Anglo-German harmony and ever-closer cooperation, I have written this post.

It explains that there are bad deficits and good deficits.  Or, in the words of Ecclesiastes: “To every thing there is a season, and a time to every purpose under the heaven:” a time to cut taxes and a time to raise taxes, a time to borrow and a time to refrain from borrowing.

Today is a time, even Ecclesiastes would agree, made for increased government borrowing, provided a few key conditions are satisfied.

The diminished role of monetary policy

The paralysis of financial intermediation today means that monetary policy (cuts in the official policy rates) have become largely ineffective in stimulating demand. Such cuts now appear to have little if any effect on either the marginal cost or the availability of external funds to non-financial enterprises and households. For individual open economies, the exchange rate provides a mechanism for stealing aggregate demand from the neighbours. If most of the neighbours are also in a situation of deficient aggregate demand, this redistribution of global effective demand – which is all that changes in exchange rates accomplish – robs Peter to pay Paul and is not part of a global solution at all.

The continuing importance of liquidity policy

Central banks are doing the right thing by massively expanding their balance sheets to put as much liquidity into the economy as possible. The balance sheets of the Fed and of the Bank of England have doubled since the crisis started and the balance sheet of the Eurosystem has expanded by about 50 percent. This has been accomplished through open market operations of various kinds, through which the central banks have increased their holdings of private securities by expanding the monetary base, mainly by increasing bank reserves with the central bank and other central bank loans.

Central banks will have to continue to do this. The private financial sector has to deleverage massively, but would (with credit markets and wholesale financial markets closed for business) do so in an unnecessarily destructive way if left to its own devices. The household sectors in the US, the UK and a number of other European countries have to deleverage (start saving seriously) on a significant scale. Left to its own devices, the short-run Keynesian aggregate demand fall-out from a necessary reconstruction of household financial wealth could be disastrous. So the public sector has to leverage up (borrow) at the same time the household sector is forced to deleverage.

This process of monetisation of private sector financial instruments can continue almost indefinitely. It is restricted only by the total stock of private financial instruments outstanding and by the central bank’s willingness to add private securities with higher and higher degrees of default risk attached to them to its balance sheet.

The central bank as the handmaiden of fiscal policy

With monetary policy almost powerless and with liquidity provision also subject to strongly diminishing returns, a traditional fiscal stimulus is the only show in town that has not yet been tried.

In an earlier post to this blog, I raised the possibility that the UK might face a triple financial crisis: a combined banking crisis, sovereign debt crisis and sterling crisis.  Let me be clearer than I was before about what I mean by a financial crisis.  A financial crisis is a situation where quantity rationing of would-be borrowers and would-be sellers of securities suddenly replaces normal market clearing through variations in interest rates or market prices of securities. 

So a sterling crisis does not require a fixed or managed exchange rate regime for sterling.  It can occur even when sterling floats, that is, when its external value is market-determined, as it is today.