May 13, 2015

The continuing saga that is the Greek debt crisis and the surprisingly convincing Tory election win in the recent UK elections, once again focuses the spotlight on the sustainability of budgetary positions and prospects for further fiscal policy tightening (“austerity”) in the major economies.  It begs the question, “Are we nearly there yet, or are we still on the road to austerity?”

The question has importance for two main reasons: 1) it tells us about the magnitude of potential growth headwinds and 2) since Quantitative Easing liquefies assets in the banking system, and in the process removes government liabilities from the market, it necessarily diminishes government debt market liquidity.

Chart 1 shows the level of general Government primary net lending/borrowing, that is the net borrowing/lending when interest costs are excluded: the data is a percentage of GDP.

2015.05.13 Blog Chart 1 Pic

The chart also shows, assuming these economies maintain the growth rate of last year and can continue to finance at current exceptionally low levels of real yields, the degree of fiscal policy tightening required (the “shift”), or permissible easing, that would stabilize the net debt/GDP ratio at the level of last year. Several things stand out:

  • While Greece is running a primary surplus (its cyclically adjusted surplus is around 7% versus the current surplus of 1%), albeit modest, as it did from 1994-2002, the additional tightening required to stabilize its debt ratio is 5.9% of GDP.
  • The UK currently runs a primary deficit of almost 4% of GDP (it has run a surplus in 6 of the last 25 years and a deficit now for the last 13 years) and requires additional tightening amounting to 3.7% of GDP, or £66 bn, from the new government in order to stabilize the debt ratio. That would mean some harsh choices – the required shift is the equivalent of 45% of spending on public pensions, 50% of the NHS budget, 73% of the schools budget, 60% of the social   security budget and almost 150% of the defence budget, give or take a few pounds. It is approximately 9% of total UK government spending.
  • Both France and Spain also require sizeable additional tightening in order to stabilize debt ratios, 2.4% and 3.3% of GDP respectively, just shy of €90 bn in aggregate.

Chart 2 illustrates what happens if we extend the analysis to include the US and Japan.

2015.05.13 Blog Chart 2 Pic

  • Japan, with a current primary deficit of 7% of GDP, requires a 4.5% of GDP fiscal policy tightening, at near zero bond yields with Bank of Japan QE amounting to 15% of GDP annually and giving them a current holding of one-fifth of the outstanding debt stock, just to stabilize the debt ratio.
  • Even the United States requires a further 3% of GDP fiscal policy tightening from here to stabilize its debt ratio.

Interestingly, Germany could afford to ease fiscal policy by 2% of GDP under our assumptions and the debt ratio would be stable. That, in our opinion, seems quite unlikely.

Adding the required shift/tightening together for these 10 countries gives us a €800 bn fiscal policy tightening in aggregate in order to stabilize government finances across the board.

That would be an extraordinary headwind to a global economy where the median real growth rate is currently just 2.3% and median core inflation rate is just 1.1%.

Even if you relax the growth assumption in favour of a far, far more optimistic assumption that these economies can grow at the fastest annual rate that they have managed in the last 20 years, the required fiscal tightening is still in the order of €700 bn. Whatever way you cut the numbers, we can safely say we are still on the road to austerity. That means, of course, the risk of a monetary policy “mistake” is severe – at exceptionally low inflation rates monetary policy must accommodate fiscal policy, not fight it.