What Needs To Be Done To Get Out Of The Mess

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by: Lok Sang Ho

The recent declines in global stock markets do not bode well for the economy, and they reflect a collapse in confidence about the remedies that government ministers and central bankers have prescribed to “help the economy.” You cannot blame people for this loss of confidence, because the remedies that have been proposed so far have either fallen short of what was necessary to deal with the problem, or even worse, have worsen the outlook for the economy and hence the outlook for effectively dealing with the debt problem.

One of the basic lessons that students of macroeconomics learn is that in order for the debt problem not to blow up, one necessary condition is for the nominal growth rate of the economy to be higher that the interest rate paid on the national debt. This requirement is easy to demonstrate. It is not a sufficient condition, but without this condition being satisfied, the debt problem will only get worse.

For this reason, any policy that undermines the nominal rate of economic growth, or a lack of policy response to ensure that the interest rate required of the government debt be lower than the nominal rate of economic growth, cannot be reassuring.

In the case of the Greek debt problem, the economy is not growing at all, and the rate of inflation is less than 2 per cent. The nominal growth rate of the GDP is negative, but the interest rate is awfully high because of the premium on default risk. Austerity measures that fail to address this issue will not help reduce the debt to GDP ratio at all. Indeed the debt to GDP ratio is bound to rise.

Similar reasoning shows that Cameron’s strategy to contain the British debt problem is not going to be successful. Fiscal austerity that reduces the rate of growth to virtually zero in the case of the U.K. will not lower the debt to GDP ratio at all.

When Ben Bernanke announced its QE2 policy, I thought it was really not necessary. The signs as observed in the private sector were quite positive. Household debt problem, for example, had been alleviated significantly. I did not at that time realize that fiscal austerity was very severe at the state level. Many state governments were laying off staff at a brisk pace, dragging the feet of economic growth.

There is now a strong case to be made for central banks to purchase debt from governments, thus reducing the need to cut fiscal deficits rapidly. This way, nominal growth can be held higher than the rate of interest paid on government debt. Without a need to reduce government spending or raise taxes rapidly, the economy will grow, revenues will come back, and the deficit problem will become less serious.

There will be objections from those who fear for run-away inflation. But the fact is that with our economy well below potential output, the fear is for inadequacy of aggregate demand rather than excessive aggregate demand. Without excessive aggregate demand, run-away inflation is out of sight. When growth has got on track, and the economy moves closer to full employment, that is the time when the central bank sells the bonds earlier purchased, thus unwinding their positions and reducing the size of their balance sheets.

There will also be fear for possible moral hazard and more fiscal irresponsibility. But fiscal responsibility can be assured first by disallowing any increase in spending. Requiring severe CUTS in spending causes more problems than it solves.

Since it is crucial that interest rate on government debt must not exceed the nominal growth rate of the economy, the EU really should consider the idea of an EU-underwritten euro-bond. I see that as another crucial step required to get out of the mess.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.