Fiscal policy and the imperative for growth
Chair: Ms Rachel Lomax
(In partnership with Canadian Ditchley)
This conference looked at the effect of the recent financial crisis on the global economic situation and aimed to analyse which of the policies being implemented in the developed world were proving most successful in putting countries back on the path to recovery, and what needed to be done next. The background mood round the table about the global economic prospects was on the pessimistic side. While the global economy was growing strongly, the marked difference between developed and emerging markets was creating challenges. In the US and Europe the extraordinary liquidity, monetary, and fiscal stimulus measures put in place in the autumn of 2008 had not yet been withdrawn, even while vigorous growth in China and other emerging markets was leading to global inflationary pressures. Against this background, international policy agreement was proving fragile. Many participants thought that underlying flaws in US and European financial systems had not been sufficiently tackled and feared that the risks of further bubbles remained high: another crisis could by no means be ruled out, though it was difficult to know exactly where it would come from.
There was broad consensus on the past – the vast spending efforts to bail out banking systems and stave off economic depression had been necessary and had clearly worked. Successful application of coordinated macroeconomic policy had put the developed world on the road to recovery, and comparisons with the 1930s showed the advantages of rapid action. The UK’s leadership of the G20 at the critical juncture was widely praised. However, while the emergency policy response had been successful in averting a serious depression, differences over macroeconomic policy and the financial reform agenda had re-emerged as the sense of crisis had ebbed. Many participants felt that there had not been enough fundamental reform, particularly of the financial system, and some lessons appeared not to have been learnt. Countries with the most developed banking systems, where recovery was weakest, faced a somewhat paradoxical situation. Most banks had returned to profit, helped by central bank liquidity support, ultra low interest rates and government guarantees. But the crisis had left the system ‘awash with moral hazard’, and populist outrage against banks and their compensation practices was a potent political force. Meanwhile, banks’ own continuing efforts to repair their balance sheets in the face of uncertainty about future regulation were not making the halting recovery any easier.
Participants worried that, although the deterioration in fiscal balances had been an inevitable consequence of the measures taken to address the crisis, and some measures were now being taken to address the resulting deficits, longer-term structural reforms were not yet being tackled, especially in the US. The sharp spike in oil and commodity prices was adding to the challenges facing central banks, as they debated when to start normalising monetary policy. While the ECB was poised to start raising policy rates, the Federal Reserve was continuing with policies of aggressive easing. Past experience of similar divergences in approach was not encouraging.
There were different views around the table on whether we had entered a period of normal post-recession recovery, were heading for a double-dip recession or were at the start of a prolonged period of slow growth. The majority thought that a prolonged period of slow growth was most likely, while acknowledging that individual countries within the developed world were moving at different speeds, and some emerging economies were doing very well. The ‘headwinds’ for the developed countries, including from oil and commodity prices, were strong, and it was not easy to see where the growth, and the necessary jobs, would come from. On the other hand, there was broad agreement that the threat of inflation in the developed economies was low. In any case a double dip could not be ruled out.
Everyone was agreed on the need for fiscal consolidation, especially in the US and Europe. But there was much discussion on the scale, timing and pace of fiscal tightening. There was broad agreement that cutting deficits was almost always bound to lead to slower growth in the short term, unless there was scope for an offsetting fall in interest rates (which few people believed was the case in current circumstances). However, there was general acceptance that fiscal policy was intensely political; and that judging the pace and shape of deficit reduction had to be a matter for political economy in its broadest sense.
Each country’s circumstances were different. The arguments for cutting deficits quickly were that high deficits would sooner or later lead to levels of debt which could only be financed at damagingly high interest rates. While there was scope for argument about the precise levels at which debt (and deficits) would prove unsustainable, markets tended to move in jumps, often unpredictably. They required concrete evidence of governments’ real determination to act. Frontloading of reductions could provide this. Those participants who took the view that all public spending was distortionary argued that early action would improve the economy’s medium term growth potential. Proponents of a more measured approach to fiscal consolidation pointed to the danger of making rapid, sweeping cuts: this would reduce demand unnecessarily at a critical and fragile moment, adding to the fiscal deficit, and in the worst case pushing the economy back into recession. There was plenty of evidence that short run unemployment could impose long term economic and social costs, as people – especially young people – became detached from the labour market.The risks of a political backlash were increased, with unpredictable and potentially ugly consequences. Sustained popular support was essential for any radical fiscal rebalancing. Fiscal consolidation had to be perceived to be fair as well as necessary in order to be broadly acceptable. This was difficult to achieve at times of low growth and against the background of a rise in populism, in Europe as well as the US.
There was agreement that the credibility of government plans was crucial. While market reactions were not always easy to predict, the general view was that analysts and credit rating agencies were looking for more than short term fixes. What they were looking for above all was evidence of commitment to a serious long term plan for fiscal consolidation owned by a government with the political credibility to carry it through. To be taken seriously any plan would need to tackle long-term structural problems, in particular those posed by the impact of ageing populations on pensions and healthcare programmes.
There was some debate about the relationship between fiscal policy and growth in the medium term. In this context there was general agreement that the quality of spending was as important as the amount. A key issue was was the balance between cutting spending on consumption as opposed to investment. There was always a strong political incentive to cut investment since large reductions could be achieved relatively quickly with less pain to consumers and voters. Large transport projects with long payback periods were particularly vulnerable. But this approach could have a very damaging effect on potential growth. Many participants argued in particular for maintaining or even increasing spending on infrastructure and education as being the most conducive to sustainable growth and increased productivity, always recognising that money had to be well spent if investment was to be worthwhile, and that this might require difficult reforms. There was much discussion of the need to scale back pension schemes, by extending retirement ages and cutting back on entitlements. As well as protecting public sector budgets, extended working lives would add to labour supply and improve potential growth. This was already happening in some countries in Europe, and there was some reason to hope that public support for these developments was growing. People were in many cases willing, even keen, to work longer, but there had to be jobs for them to take.
This discussion also led to wider consideration of the effects of the current trend in many countries, especially the US and the UK, towards greater income inequalities, notably between those at the very top of the earnings scale and the rest. For example the top 1% in the US had received the bulk of the growth dividend over the past thirty years and now owned an astonishingly high percentage of the nation’s wealth; meanwhile those on median wages and below had seen little or no increase in their living standards. It was unclear whether widening inequality was damaging in narrowly economic terms – arguably not, if those who had the money were investing and spending it in ways which increased prosperity overall. Against that, widening inequality might set up some economically damaging dynamics – for example it had been argued that the desire to mitigate widening inequality lay behind the political support in the US for the (ultimately disastrous) growth in sub-prime lending which led to the financial crisis. There was no doubt that evidence of glaring and growing inequality was making it harder to mount a compelling case for fiscal austerity. It had certainly served to turbo charge public hostility to banks. There was a general feeling that it was very hard for governments to reverse these trends, since they were closely allied to globalisation and technological change – one reason why they were particularly evident in highly globalised and mobile sectors like the financial sector. This was seen as a good potential area for a further Ditchley conference (there are plans to include it in the 2012 programme).
On the revenue side, there was much discussion on how far tax increases needed to be part of fiscal consolidation, in addition to spending cuts. Some argued that there was no way of avoiding this, particularly if the process was going to be seen as fair, since spending cuts always tended to affect the poor disproportionately. Moreover some spending cuts were economically damaging. However, tax increases risked reducing future growth and, in a globalised world, it was difficult to increase direct taxes on companies and wealthy individuals without sparking a damaging exodus. There were no easy answers in this area, and clearly the individual circumstances of each country had again to be fully taken into account. However suggestions which could be valid in many countries included taxing the financial sector more, introducing a carbon tax, simplifying tax structures (in many countries the complexity of exemptions and entitlements had reached absurd levels), introducing or increasing VAT, increasing real estate taxes and doing more about tax evasion.
We discussed the difficulty of generating the necessary political will on both the spending and revenue sides if some of these long term issues were to be successfully tackled. Those with practical experience emphasised the need to take people with you when taking tough economic decisions. Otherwise the risk of political trouble and reversals later was too high. Whenever possible, rapid swings from one policy to another should be avoided and a long term plan adopted. People could understand the need for tough measures if they were properly explained, with real transparency. There was agreement that, in order to tackle these complex challenges, the incentive structures within which politicians operated in democracies needed to be reformed. Otherwise it could simply be too difficult to undertake long-term structural reforms when politicians were bound to be looking at relatively short-term outcomes and their effect on electoral prospects. Removing certain instruments from political control, as had been done with the Bank of England, could help remove constraints on effective policy-making. Fixed fiscal rules could also have a role to play, even if experience suggested that they tended to be abandoned when the going got tough. In any case there was a need for more reflection on how greater decision-making space for politicians could be created – again a further Ditchley conference on the issue was suggested.
We spent a lot of time on the approach of the financial markets. There was agreement that the notion of markets ‘attacking’ particular countries at particular moments was false. When the markets lost confidence in a country’s ability to pay its debts, there were almost always good reasons for this. In any event market views, right or wrong, were decisive where deficits were wholly or largely financed through market borrowing. But while markets were not irrational in any simple sense; they were clearly driven, as one participant put it, by ‘fear as well as greed’, and prone to wild swings and over reaction as a consequence. Markets were often slow to notice problems in a particular country, had persistently mispriced risk, tended to focus on a limited number of situations at a time, and once they did begin to worry about a particular country’s situation, had a tendency to overshoot, because of herd-like habits. One way for countries to deal with this was to be more transparent about their policies and their problems, over time, and thus establish credibility, in the same way as any other borrower. There was wide criticism of the role of rating agencies, who also seemed to have learned little from the crisis.
In this context, participants gave much attention in the discussion to the apparent absence of political consensus in the United States on how to tackle their deficit issues and the implications this had for the rest of the world and the global financial markets. While few in the US disputed the need to take action, there was so far little agreement on what could or should be cut, the big ticket areas like defence spending and social security/health entitlements would always be highly controversial, and tax increases would be a very hard sell. In practice political gridlock in the United States appeared to have blocked movement towards major fiscal consolidation in the short term, and the prospect of the Presidential election next year suggested that a plan for long-term budget consolidation would have to wait. A collapse in market confidence in the US fiscal system was not necessarily imminent, but there were worries that, without a long-term plan, levels of debt within the US would pose an increasing risk to the rest of the world. Would bond markets always look as kindly on the US as they were currently doing? If a crisis did come, it might come abruptly, and would have catastrophic effects for others.
There was wide agreement that a major effort of political will by all concerned would be needed to reduce unsustainable spending levels, given the strong political resistance to tax increases in the US – the Republicans in particular took the view that the only way to reduce government spending was to ‘starve the beast’. At the same time, it was pointed out that below the federal level, spending was already being cut radically because states had no choice but to balance their budgets. Some took the view that the US system would eventually react as needed, and the markets knew that – hence their current calm. US demography and longer term growth prospects were also better than elsewhere.
There was a similar but briefer discussion of the Japanese position. The fact that 85% of Japanese debt was internally financed helped to explain why it had been possible for Japan to accumulate historically very high levels of public debt, relative to GDP, without precipitating a sovereign debt crisis. But it was unclear whether this was a sustainable long term position. How long could Japan continue with European welfare levels and US tax rates?
Participants were also interested in the wider international context for these different approaches to fiscal policy. On the one hand, if all countries were trying to cut their deficits simultaneously, the chances of stifling growth all round were much higher – and it was not possible for all countries to export their way out of trouble at the same time. In these circumstances US policy and a decent US economic recovery were supporting growth elsewhere. On the other, a collapse in financial market confidence in US policy would have disastrous implications for many countries around the world.
The conference spent some time on this wider global picture. Developing countries had been less directly affected by the financial crisis, and had bounced back quickly from the collapse in trade over the winter of 2008-09. Those, like China, who maintained more or less fixed exchange rates against the dollar had effectively imported the highly expansionary monetary policies which were needed to fight the recession in the US. The big emerging economies, in particular China and India, were now driving global growth, though recent growth rates had been more modest in Latin America, the Middle East and Africa, and even some parts of Asia. Prices and wages were rising rapidly in the high growth countries, and there was now a serious risk of overheating. Asset bubbles in China, particularly in real estate, were seen as highly likely. Meanwhile global challenges facing both emerging and developed economies were increased by growing commodity, oil and food prices. The Japanese nuclear problems following the earthquake and tsunami would only worsen these challenges, especially if important countries turned against nuclear power, and thereby increased global dependence on oil. This should be avoided if at all possible.
The conference naturally spent a good deal of time on the crisis in the eurozone, and the difficulty of finding a coordinated, coherent response adequate to the size of the problem. Some thought that the eurozone in its current form could not last because of its inherent contradictions (countries unwilling to accept the logical consequence of common fiscal policies, for example), but most thought that the political will to maintain it was so strong that it would muddle through somehow. Most participants believed that Greece, Portugal and Ireland would at some stage have to default or restructure their sovereign debt, because the burden on taxpayers and voters was simply unacceptable. At the very least interest rates on the bail-out loans needed to be reduced significantly. Some argued that Germany was imposing ‘Versailles’-style reparations on the poorer countries, thus failing to acknowledge that every rash borrower in Greece or Portugal had a rash lender as counterparty in countries like Germany or France. The problems in Ireland in particular had come from the financial system, not from government fiscal profligacy. German reluctance to spend more of its own money bailing out others was understandable in domestic political terms, but was short-sighted. Moreover Germany and France had helped sow the seeds of the current situation when they had failed to abide themselves by the Growth and Stability Pact (and the ECB bore some of the responsibility through its failure to distinguish between risks for different eurozone country bonds, which had lulled the markets for some years). While many saw the Versailles analogy as a little strong, most agreed that Germany was not currently acting in its own best interests, let alone those of Greece or the eurozone.
Despite these problems, it was argued that Europe was in many ways in better shape than the US, since at least the fiscal problems were being tackled. Some important longer term steps were also being taken quietly, for example in the area of pensions and retirement age reform. But there was also a feeling that the eurozone continued to face severe market risks, which it was underestimating because of current relative calm.
We looked at the state of international cooperation to deal with the consequences of the financial crisis. Here a clear distinction was drawn between the effectiveness of initial coordinated efforts, and the current apparent loss of momentum and even complacency, for example over international cooperation on regulation of the financial sector. The G20 had gone from focussed action to vague discussion, and seemed to have lost its way. Countries like China seemed to have lost interest altogether in further coordinated action, and to regard current issues as not their problem, an attitude which could prove fatally short-sighted. This complacency worried a lot of participants. The issue of toxic assets in parts of the banking sector had not yet been resolved in some places, for example. Macro-prudential policy was another area where there was little international coherence for now. Another crisis could by no means be ruled out, even if it was hard to see exactly where it might come from at this stage. Many participants felt that it was unfortunately inevitable that international cooperation would languish until backs were once again against the wall.
In these circumstances one way to improve global cooperation might be to start with small groups, for example regional gatherings, which could make decisions on certain issues and work up towards a global framework. Meanwhile the case was strong for keeping the G7/G8 and G20 as focussed and informal as possible. Their ability to adapt to issues was what gave them their usefulness and their remit should not be too formal or expanded too widely. For example the list of issues on the G20 agenda should be reduced, with the focus kept on financial sector reform, and on keeping China interested and involved. This building block approach to international cooperation was seen as most likely to be effective in present circumstances. No-one thought that new institutions were needed now, although it was possible that a future crisis would spawn a more radical look at the international economic and financial architecture, for example a new Bretton Woods-style conference. Proposals for a different sort of reserve currency eg some kind of SDR system, could be well worth exploring at some stage.
Elsewhere in the world of relevant international institutions, the IMF was seen to be doing a reasonable job but needed to step up its role in making sure the right advice was available to countries struggling with deficits. The OECD could also play a stronger role. The role of the World Bank and Regional Development Banks was not seen as central for these purposes. Interestingly, and perhaps mistakenly, we did not spend much time on the WTO or trade issues, but there was agreement that concluding the Doha round would be hugely beneficial for the world economy, if only the (relatively minor) issues standing in the way could be resolved. Conversely, failure to finalise Doha could weaken the WTO badly. One conclusion meanwhile was that the world had learned some valuable lessons from the 1930s and other similar crises, in that protectionist, beggar-thy-neighbour reactions had been largely avoided. The feeling from US participants was that even US/Chinese tensions over the exchange rate of the renminbi could be managed – it had not (yet) become an issue of real populist concern in American politics. This was encouraging.
There were no silver bullets on display for the complex problems of the world economy but some broadly agreed directions for ways forward did emerge from the discussion described above. In summary these include:
o Eliminating tax system distortions;
o Reforming entitlements;
o Greater efforts to tackle tax evasion;
o Favouring indirect taxation on sales and real estate;
o Looking hard at spending patterns to ensure they were the most conducive to growth and increased productivity;
o Targeting public spending on investment;
o Concentrating investment on education and infrastructure.
The lessons of the last crisis needed to be fully implemented. Current complacency was dangerous while structural reform of the financial sector remained half completed.
Fiscal rebalancing was essential wherever deficits were excessive but the process needed to be transparent and have popular support. Credibility was more important than speed, especially when so many developed countries were trying to consolidate simultaneously and the downward pressures on growth were thus greater.
Fiscal policies to achieve rebalancing should include:
Longer-term structural reforms of healthcare and pension policies had to be tackled simultaneously if they were not to undermine consolidation very quickly in the future.
Tackling inequality of income, however difficult, was crucial to maintaining political support for the necessary fiscal measures.
While the rest of the world could do little about helping the US tackle its fiscal problems, and there were reasons for hope, it was wise to prepare for the worst.
The eurozone still had some way to go to resolve its internal issues, and should face up soon to the reality that the current predicament of countries like Ireland, Greece and Portugal was unsustainable politically.
International cooperation was still urgently needed. The G7/G8 and G20 would remain the crucial fora and should retain their flexibility of agenda and approach.
China and the other major emerging economies needed to be convinced of the dangers they now faced, despite their high growth rates, and of the need for them to engage in international efforts to avert a new crisis.
The developed countries needed to learn to live within their means for the long term.
A concerted effort to make the continuing case for nuclear power was needed, to avoid even worse dependence on high-priced oil.
Although the overall mood of the conference was pessimistic, we recognised the wisdom of the words of our chair that this was a natural reaction to the crisis we had just been through (a conference five years ago would have been very optimistic about the prospects, and completely mistaken!). Global recovery might, after all, continue without further major disruption. Meanwhile the high levels of growth in China, India and other major emerging economies were continuing to lift hundreds of millions of people out of grinding poverty, which was good news for us all.
Director, National Institute of Economic and Social Research (2011-). Formerly: Chief Economist, Cabinet Office; Chief Economist (Work) and Director, Children, Poverty and Analysis, Department for Work and Pensions.
Mr Lucas Merrill Brown
Rhodes Scholar; MPhil Candidate in Economics, Magdalen College, University of Oxford.
Dr Richard Medley
Founder & Chairman, RHM Global LLC, New York. Formerly: Founder (2005), a direct credit fund (2005-11); Founder (1993), Medley Global Advisors (1993-2005).
Ms Maya MacGuineas
President, Committee for a Responsible Federal Budget (2003-); Director, Fiscal Policy Program, New America Foundation (2000-). Formerly: Senior Policy Analyst, The Brookings Institution (1997-98).
Dr Adam Posen
Peterson Institute for International Economics (PIIE), Washington DC (1997-); Senior Research Fellow, formerly Deputy Director, PIIE; External Member, Monetary Policy Committee, Bank of England; Member, Panel of Economic Advisers, US Congressional Budget Office; Author.
USA/SOUTH AFRICA
Mr Christopher Loewald
Deputy Head, Research Department, South African Reserve Bank (2011-). Formerly: Deputy Director-General, Economic Policy Division, South African National Treasury (2006-11).
USA/UNITED KINGDOM
Mr Francis Finlay
Chairman, EastWest Institute, New York (2009-); Trustee, British Museum (2005-); Member, Oxford Martin School; Advisory Council, University of Oxford (2005-); Governor, London Business School (2003-). A Governor, Member of the Council of Management and Chairman of the Finance and General Purposes Committee, The Ditchley Foundation. A Director, The American Ditchley Foundation.
WTO/Switzerland
Dr Marc Bacchetta
Counsellor, Economics Research and Statistics Division, World Trade Organization (1996-). Formerly: Senior Economist, World Bank (2002-04).