Qou Vadis, QE?

Ever since the first rounds of quantitative easing (QE) by the US Federal Reserve, I’ve raised questions about how sound and sustainable this form of monetary policy is? How big is the risk that the greatest economic experiment in modern history may eventually fail? More than three years later, I’m still not sure. The only thing I’m sure of, is that the need for extreme measures is greater than ever.

“It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution. What matters is growth.”

George Irvin

(Photo by freakingnews.com)

While Mr. Ben Bernanke in the USA is trying to figure out new and more creative ways to flow the financial system with money in order to kick-start the nation’s economy, European politicians are obsessing over new and creative austerity measures in order to save money and regain the union’s financial balance. But nothing seems to work. 

In 2008 I called for the launch of a so-called “Keynesian war” – but with a twist:

Instead of increasing public spending the traditional way, by investing in infrastructure like transport and housing or by upgrading public institutions like the military, I suggested to aim the financial “guns” at research and education, closing  the gap between the rich and the poor, and developing clean energy.

The “Keynesian war” was launched, all  right. But the ammunition was poured into the banks and other financial institutions who barely manged to save their own asses, in addition to dump the problems on their respective  national governments.

The financial crisis is currently well beyond the stage I regarded as a “worst-case-scenario” only two years ago.

So, where do we go from here?

One thing ought to be clear: It’s no longer a question of method – the only thing that matters is the result.

Honorary professor George Irvin at University of London makes a pretty good summary in his latest blog post at the EUobserver.com.

The Debt Trap 

“Europe is obsessed with the growing stock of public sector debt; fiscal austerity has become the watchword of our time. Little does it seem to matter that fiscal austerity means reducing aggregate demand, thus leading to economic stagnation and recession throughout the EU as all the main forecasts are now suggesting,” Professor Irvin writes.

Even the credit rating agencies are worried, as S&P’s downgrading of France and eight other countries shows. Whether it’s Angela Merkel or David Cameron speaking, public debt is denounced as deplorable, and all are told to get used to hard times.

As Larry Elliot puts it:

“The notion that economic pain is the only route to pleasure was once the preserve of the British public school-educated elite, now it’s European economic policy”.

In Britain, immediately after the general election, the Tory-led coalition decreed that in light of the large government current deficit, harsh cuts were necessary to win the confidence of the financial markets.

But although the current deficit was high, the stock of debt (typically measured by the debt/GDP ratio) was relatively low and of long maturity, the real interest rate on debt was zero (and at times negative) and, crucially,

Britain had its own Central Bank and could devalue. As Harriet Harman argued in June 2010, Osborne’s cuts were ideologically motivated. The aim was to shrink the public sector, and the LibDems—fearing a new general election—chose to go along with the policy.

In the euro zone (EZ), where a balance of payments crisis at the periphery has turned into a sovereign debt crisis, the German public has been sold the idea that if only all EZ countries could be like Germany and adhere to strict fiscal discipline, all would be well.

The ultra-orthodox Stability and Growth Pact (SGP) has now been repackaged under the heading of ‘economic governance’ under which Germany and its allies will vet members’ fiscal policies and impose punitive fines on those failing to observe the deflationary budget rules to be adopted.

Never mind the fact that indebtedness in countries like Spain and Ireland was mainly private, or that the draconian fiscal measures imposed on Greece have, far from reducing public indebtedness, increased it.

Is debt always a bad thing?

In the private sector, obviously not since corporations regularly borrow money for expenditure they don’t want to meet out of retained earnings, while most households aim to hold long-term mortgages.

Public debt instruments like gilts in the UK or bunds in Germany are much sought after by the private sector, mainly because such instruments are thought to act as an excellent hedge against risk.

Remember, too, that when a pension fund buys a government bond, it is held as an asset which produces a future cash stream which benefits the private sector.

So ‘public debt’ is not a burden passed on from one generation to the next.

The stock of public debt is only a problem when its servicing (ie, payment of interest) is unaffordable; ie, in times of recession when growth is zero or negative and/or interest rates demanded by the financial market are soaring.

The question is when is debt sustainable?

Sustainability means keeping the ratio of debt to GDP stable in the longer term.

If GDP at the start of the year is €1,000bn and the government’s total stock of debt is €600bn, then the debt ratio is 60%; the fiscal deficit is the extra borrowing that the government makes in a year – so it adds to the stock of debt.

But although the stock of debt may be rising, as long as GDP is rising proportionately, the debt/GDP ratio can be kept constant or may even be falling.

Consider the following example. Suppose the real rate of interest on debt is 2% (say 5% nominal but with inflation at 3%, so 5 – 3 = 2). That means government must pay €12bn per annum of interest in real terms. But as long as real GDP, too, is rising—say at 2% per year—there’s no problem since real GDP at the year’s end will be €1020bn.

Even if the government were to pay none of the interest, the end-of-year debt/GDP ratio would be 612/1020 or 60%; ie, the debt ratio remains unchanged.

By contrast, if real GDP growth is zero, the ratio would be 612/1000 = 61.2; ie, the debt ratio rises only slightly. 

The rule is that as long as the real economy is growing by at least as much as the real rate of interest on debt, the debt/GDP ratio doesn’t rise.

Moreover, this holds true irrespective of whether the debt ratio is 60% or 600%.

But there’s a catch.

In a modern economy, the public sector accounts for about half the economy.

If a country panics about its debt ratio and cuts back sharply on public sector spending, this reduces aggregate demand and may lead to stagnation or even recession.

When a country stops growing, financial markets decide that its debt ratio may rise and so become more cautious about lending and demand a higher bond yield (ie, interest rate).

The gloomy prophecy of growing public indebtedness becomes self-fulfilling. This is exactly the sort of “debt trap” which faces much of the EU and other rich countries. The way out cannot be greater austerity.

What works for a single household or firm doesn’t work for the economy as a whole. A household can tighten its belt by spending less, saving more, and thus ‘balancing the books’, but an economy cannot.

If everybody saves more, national income falls.

Of course, Germany and some Nordic countries can balance the government books because an export surplus offsets domestic private saving. But the Club-Med countries cannot match them.

When no EZ country can devalue, to ask each EZ country to balance the books by running an export surplus is empirically and logically impossible.

Even if all could devalue, what would follow is 1930’s-style competitive devaluation.

The way out of the ‘debt trap’ is the same as the way out of recession: if the private sector won’t invest, the public sector must become investor of the last resort.

It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution (some combination of the three would be optimal).

What matters is growth.

By George Irvin

George Irvin is a retired professor of economics and for many years was at ISS in The Hague. He is now honorary Professorial Research Fellow in Development Studies at the University of London, SOAS.

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