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Over the past week or so, I have spent a lot of time on sovereign debt and the problems being faced by various nations with respect to their budget deficits. I suggest the article “Sharing the Pain” in the March 4, 2010 edition of The Economist as a good compilation of issues relating to the situation many countries are now facing. This piece is contained in the briefing, “Dealing with Fiscal Deficits.”

We can separate the discussion into three categories: the problem, the pain, and the pragmatic response.

First, the problem. History shows us that when economies slow down, budget deficits appear or widen. Revenue growth declines as the need to increase outlays rises. Put this general movement on top of decades of undisciplined management of government budgets and you can get “one hell of a problem.”

The Economist article states that, “deficits in several countries have increased so much and so fast during the economic crisis of the past 18 months or so that it is generally agreed that remedial action will be needed in the medium term. Deficits of 10% or more of GDP cannot be sustained for long, especially when nervous markets drive up the cost of servicing the growing debt.” It continues, “when markets do lose confidence in a government’s fiscal rectitude, a crisis can arise quite quickly, forcing countries into painful political decisions.”

Second, the pain. History shows, according to Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard, that it is highly unlikely that the “rich countries” of the world will experience a burst of rapid and prolonged growth. “Sluggish growth is more likely” and “the evidence offers little support for the view that countries simply grow out of their debts.”

“So, short of debt default or implicit default via inflation, that leaves just two other ways of closing the deficit. Spending must be cut or taxpayers must pay more.” Hence the pain!

Here we can point to the situation in Greece where much of the effort to return some fiscal discipline to the country is falling on cuts in government wages and in social benefits. This has resulted in substantial personal retrenchment and civil unrest. Today we read of a second general strike in the nation that closed all public services. See, “New Strike Paralyzes Greece.”

The deficits are so large in most of the affected countries that minor adjustments to spending or taxes will have little or no impact. The budget adjustments that must be made are quite substantial: hence the depth and breadth of the pain.

In recessions that are relatively minor, government monetary and fiscal stimulus seems to restore economic growth, thereby rectifying the situation and minimizing the pain. But, in a recession of the magnitude of the Great Recession, the government does not seem to be able to “buy” itself out of the trouble. Hence, the spread of the pain.

Furthermore, there is an added difficulty that enters the picture in the more extreme cases. Those that are more affected by the recession and by the adjustments that need to be made in government budgets may come to see the changes as a break in the “social contract” of the country. This government that saw to their welfare, put them to work and sustained them through the minor crises of the past, now seems to be abandoning them. And, for whom? The international financial community!

Obviously, if we get into this state of affairs, the emotions can become quite high, as in Greece.

This leads us into the third category which has to do with what governments can do in such situations. The problem with the situation brought on by large budget deficits and a growing national debt is that there are no good solutions. Anything the government does in an attempt to get the budget under control while encouraging the economy to recover hurts someone.

This is why governments must be very pragmatic in what they propose. Doctrinaire approaches just do not seem to work. There are only two suggestions from the historical perspective that seem to have borne some fruit in the past. The first is that there needs to be some “social cohesion” in the country to achieve some success in the effort to get the country’s budget under control. The second is that governments “should focus on spending cuts rather than tax increases.”

The article in The Economist points to two instances where successful government tightening has taken place in recent memory: Sweden and Canada. In both cases the crisis in the country became acute enough and the ruling governments acted in a sufficiently pragmatic way so that voters finally got behind the efforts. However, this social cohesion was not always achieved on the first attempt.

Some of the social cohesion can be gained by raising some taxes, especially on the “better off.” This may be the “quid pro quo” for the less well off to accept the other things that need to be done. The downside to this is always that the “better off” have more escape hatches that will allow them to avoid any imposition of taxes they feel are excessive. And, many countries in the past twenty years or so have built up reputations as “low tax havens” to attract business. Ireland, for example, lowered its corporate tax rate to just 12.5% and is very reluctant to increase this and harm the climate they benefited so much from. If taxes go up on these people and businesses, they can be very mobile and move to less oppressive environments. Also, tax evasion can be a huge problem, especially against sales or value-added taxes.

So, the burden of fiscal tightening falls on the spending side, but this is not an easy road either. And, when one looks at the “big” targets for cuts, good arguments for not making cuts abound. Military spending is not a major item in many countries needing budget cuts, but it is in the United States. Here, there are two wars being fought and the need to maintain the world’s “top” military machine and keep it current through research and development makes the budget almost non-touchable.

The next major item that comes up on the list to consider is government employment. Over the last 50-60 years, governments throughout the world have exploded in terms of providing employment. Over the last several years the rate of government hiring has gone up, especially in the United States, in an effort to deal with the financial crisis and the Great Recession. Is it realistic to think that governments will shrink in size or in terms of payroll expenses? This is where Greece and Ireland and Portugal and Spain have promised to do something. And, of course, this is where much of the civil unrest has come from.

Next, social programs, a huge item in many government budgets and the primary cause of the expansion of government budgets in the post World War II period. (For more on this see Niall Ferguson’s book “The Ascent of Money: A Financial History of the World.") The Economist suggests that one area that can be rationalized here is the pension system in these countries.
And, there are other ideas available.

The thing the article (implicitly) points out is that the way out of the fiscal dilemma is not easy. But, I suggest three further things that need to be considered. First, leadership. The countries facing the problems discussed here need to have someone out in front that is understood and trusted. The only way out of this situation is pragmatic: not progressive, not conservative, not liberal, not socialist, or any other dogmatic approach. But, to achieve the “social cohesion” necessary for success, there must be leaders that draw people together.

Second, the proposed solutions cannot just force people back into the way things were. One reason for the depth and breadth of the Great Recession is the changing structure of the society and culture. (For more on this see my post here.) If this is true, then the leadership must be forward-looking rather than serving just entrenched interests.

Finally, this will not be easy. As The Economist article closes: “There are many battles over deficits to come. Well chosen policies that foster growth may make them less fierce. They may be bloody even so.” Amen.

Source: Budget Deficits and Recovery