Let's hear it for easy money

Britain, along with much of the western world, has (barely) managed to crawl its way out of recession. That it has done so is mostly thanks to unprecedented and, I dare say heroic, government easing. For two years, monetary policy has been spectacularly loose, with interest rates close to zero, and fiscal policy has been hugely expansive, with deficits more than doubling. Finance ministers haven’t had much choice. With the private sector deleveraging, households and businesses saving instead of spending, the government has had to step in order to maintain demand. Imagine what a mess we would be in today with interest rates at normal levels and without massive deficit spending. Unemployment would be through the roof. But all this government expenditure, combined with lower tax revenues, has pushed deficits to almost wartime levels. The question is: will bond markets continue to shrug off what some see as unsustainable budget deficits?

Economists are fighting a civil war over what is more frightening: government deficits or their eradication. We should all pay attention, because the consequences of either side winning could be brutal.



The debate between Niall Ferguson and Martin Wolf in the Financial Times is an excellent introduction. Ferguson looks at Greece, its budget deficit at 12 per cent of GDP, financial markets wary of lending it any more, default threatening if not bailed out by Brussels and Berlin—and sees our future. He suggests that if Britain and America don’t get their fiscal houses in order by cutting spending and raising taxes, investors will soon demand much higher interest rates, choking off any possibility of growth. His fears are not irrational; the money supply has exploded in the past two years, which according to monetarist orthodoxy means that inflation (and/or currency depreciation) are around the corner. He accuses deficit doves of naively believing in a Keynesian free lunch, and ignoring the dangers of government debt to the rest of the economy.

Wolf responds that “Prof Ferguson believes instead in a conservative free lunch”; that he forgets the vital role of the government deficit in replacing private demand and keeping the recession from getting even worse. Wolf notes that three years ago, Americans spent 102 per cent of their income, a negative savings rate. It was that willingness to borrow and spend that goosed demand and fuelled economic growth for a generation. No more. Now, even infinitesmal interest rates are not enough to prime consumption and investment. We are in a liquidity trap. Fear and uncertainty make consumers spend less and corporations invest less; falling demand creates a vicious circle leading to further unemployment and so even less demand. In this recessionary environment, traditional Keynesian economics tells us government spending is necessary and not inflationary, as it is just replacing private sector demand. Wolf argues that if we followed Ferguson’s suggestions and eliminated deficit spending “we would now be in the Great Depression redux.”

In all of this, it is worth remembering that the dangers of deficits are mostly in their effect on the perceptions of bond buyers. If deficits make investors lose confidence in the ability of governments to repay, then they will demand exorbitant yields and that will indeed be a vicious brake on economic growth. So far, the bond market seems happy enough to lend. Right now, the 30-year UK bond is yielding only 4.6 per cent. This doesn’t suggest that the market fears either British default or inflation. Perhaps we can take comfort that the worry about deficits remains localised in the more right-wing sectors of the economic establishment, rather than in the financial markets.

Finance ministers do have to sail between Scylla and Charibdis, keeping rates low and spending high enough to maintain demand without sparking bond market fears of default. Right now, though, the dangers of tightening spending and deficit reduction seem far greater and far more immediate than those of easy money and a balanced budget.