Recovery or reining in deficits?

A two-day summit meeting of finance ministers and central bank governors from the word's twenty leading economies recently came to an end. It was held in Busan, the second largest city and the main port of South Korea. The principal item on the agenda was global economic recovery. In view of the growing European debt crisis, discussions centred on finding a balance between two conflicting strategies: continuing to stimulate recovery as many American economists recommend and taking drastic measures to reduce deep fiscal deficits, the primary concern in Europe.
This is not a new debate. It has been going on since 1929, when the Great Depression started. That was no doubt, the longest -- lasted until 1939 -- and the most severe economic depression in the history of the industrialised Western world. The New York Stock Exchange crashed in 1929 and stock prices continued to fall for the next few years forcing many banks and other financial institutions into insolvency because of the precipitous fall in the value of their assets and huge loan losses. It seemed that everyone was trapped in a vicious circle. People not only lost their savings but also their confidence in the economic system which made them very cautious while spending money. A continued fall in the aggregate demand caused production to fall and unemployment to rise.
Following the conventional wisdom, President Herbert Hoover thought that the best way to stop this downward spiral movement of the economy was to balance the US budget. Unfortunately, it had just the opposite effect. A contracting economy had already caused government revenue and tax receipts to fall. Further tightening of the budget meant cutting government spending. The situation kept on getting worse.
In 1930, an English economist called John Maynard Keynes came up with a new theory. He said that in depressions, market forces were not enough to achieve recovery. The government, instead of depending on the so-called theory of competitive adjustment should play a more active role. He felt that in minor recessions, monetary policy in the form of easier credit and lower interest should be enough to restore aggregate demand. But in cases of depressions, he recommended deficit spending to stimulate the economy. While formulating the New Deal which played a significant role in bringing the United States back to the path of economic recovery, President Franklin D. Roosevelt took in to account the recommendations made by Professor Keynes.
Unfortunately, history has a habit of repeating itself. In 1989, the Japanese economy was considered as one of the most dynamic and powerful economies of the world. But like the Americans in the late twenties, the Japanese were unaware of the fact that they had created an asset-price bubble economy. Fuelled by easy credit, unbridled speculation and unparalleled greed, Japanese equity and real estate markets had reached astronomical price levels.
On December 29, 1989, the bubble burst. The Japanese government slashed interest rates, provided liquidity to its banks to keep credit flowing and gave fiscal stimulus. Today, twenty years after that debacle Japan's government debt burden still stands at approximately 200% of GDP. Unfortunately, Japan is still suffering from deflation because lured by false signs of economic recovery, the government tightened fiscal policy before private demand was strong enough to sustain recovery. However, unlike Greece in the current debt crisis, the markets never lost their faith in Japan's creditworthiness.
Today, most economists recommend deficit spending in times of recession but there are serious differences of opinion among them over the size and duration of the deficit.
There is a consensus that small short-term deficits help end recessions, if they are managed properly.
A big long run deficit may lead to inflation and even worse, to the possibility of creating the next bubble. This may also induce the markets to lose faith in the creditworthiness of the country concerned as it is happening now in the cases of Greece and Hungary. High long run deficits have a tendency to become runaway deficits.
Such a situation forces the debtor country to pay ever higher premiums to service its loans and one must remember that money spent on servicing debts can not be spent for other things. It also affects perfectly healthy companies in the private sector in a perverse manner. They are forced to pay higher interest costs, which in turn make their products less competitive in the export market. As a consequence, it becomes more difficult for the troubled country to achieve economic recovery.
On the other hand, if the stimulus is withdrawn too soon it stifles demand, increases unemployment, cuts the recovery short and eventually leads to a deflationary situation as it happened in Japan.
So as Pier Carlo Padoan, the chief economist of the OECD, put it recently: "To a large extent, the issue is one of timing: when and how quickly should policy stimulus be withdrawn?" Unfortunately, there are no magic formulas, hence the need for strong fiscal frameworks and efficient government institutions that can be entrusted with the task of monitoring the constantly changing economic situation -- both national and global -- and taking timely remedial measures.
Chaklader Mahboob-ul Alam is a Daily Star columnist.