Will Public Austerity Cause Private Sector Paralysis?
As the whole world prepares for years of austerity, now that virtually everyone is aware that sovereign debt levels are unsustainable and the drive to push public sector deficits down has reached a crescendo, one question remains open: what will happen to the private sector deleveraging commenced the world over in the aftermath of the Lehman bankruptcy. Goldman's Jan Hatzius takes a look at this question, and reaches some very unpleasant conclusions. Looking at the closed system of the financial balances of the private sector, the public sector and the rest of the world (i.e., private balance + public balance = current account balance), in which the push for deleveraging in the private sector, the rush to ramp up exports, and the imminent Age of Austerity all signal an upcoming unprecedented "demand shortfall for the economy as a whole", Hatzius concludes gloomily that "given the forces of retrenchment and balance sheet repair, the risks to the growth of aggregate demand?as well as risk-free interest rates?over the medium term are tilted to the downside. Policymakers can provide some relief, but realistically will find it hard to neutralize the headwinds altogether" The economist also looks at what realist fiscal and monetary rabbits are left in the hat of the administration/Fed, and realizes that there is little that can be done to prevent what he dubs a "slowdown" and what everyone else whose bonus isn't tied in with perpetual growth assumptions, a new wave of the Second Great Depression.
First, Jan observes the dynamics of the current economic cycle. In case anyone is still confused about it, here is his summation in a nutshell: "Relative to the start of the recession, the level of employment payrolls is now about 8% lower than in the median cycle of the 1954-1982 period. Scaled to the current level of the labor force, this is a shortfall of roughly 10 million jobs. The size of this gap reflects two unusual features of the current cycle? an unusually deep recession and an unusually weak recovery." We recommend the following refresher course in one of the basic laws of economics, which the Obama administration, try hard as it might, will not be able to get the Supreme Court's repeal vote.
Exhibit 1 illustrates the extent to which the recent recession and its aftermath have diverged from postwar experience by plotting the level of nonfarm payroll employment against prior postwar cycles, starting from the peak of the business cycle (i.e. the start of the recession). Relative to the start of the recession, the level of employment payrolls is now about 8% lower than in the median cycle of the 1954-1982 period. Scaled to the current level of the labor force, this is a shortfall of roughly 10 million jobs.
The size of this gap reflects two unusual features of the current cycle?an unusually deep recession and an unusually weak recovery. This is in stark contrast to the ?what goes down must come up? pattern predicted by many forecasters, at least until recently.
The sheer size of this gap suggests strongly that the cycle is fundamentally different from its postwar predecessors. There are a number of alternative though not mutually exclusive ways of illustrating these differences. But at the most basic level, we view the distinguishing feature of the current cycle as a collective attempt by the different sectors of the economy? households, firms, governments, and the rest of the world?to reduce their debt loads by pushing spending below income. This does not mean that every sector is trying to run a surplus?as is well known, the US federal government is currently running a large deficit and planning to do so for many years. But it means that those sectors that are running deficits are moving less aggressively than those that are running surpluses. This implies a demand shortfall for the economy as a whole.
To illustrate the reasoning, Exhibit 2 shows the financial balances? the differences between income and spending? of the three sectors of the economy, namely the private sector (households and firms), the public sector (federal, state, and local), and the rest of the world. (The rest-of-the-world balance is simply the inverse of the current account balance, representing a capital inflow when the current account is in deficit.) The financial balance is the difference between total income and total spending, and in general equals a sector?'s net lending to other sectors.
Since the three sectors constitute a closed system, one sector?'s borrowing must always be another sector?'s lending. Hence, the three sectoral balances must sum to zero:
(1) private balance + public balance = CA balance.
Exhibit 1 shows the current configuration of the three balances. As of the first quarter of 2010, the private sector was running a 7% of GDP surplus, the public sector a 10% of GDP deficit, and the rest of the world a 3% of GDP surplus vis-à-vis the United States.
But while this equation must always hold ex post as a matter of accounting, it need not hold ex ante. In other words, is quite possible for different sectors to pursue spending plans that are mutually inconsistent with one another, and such inconsistencies can keep aggregate demand away from the economy?'s supply potential. In general, if all sectors taken together aim to run a financial deficit?i.e. want to spend more than their expected income and want to finance the difference by borrowing?the economy will tend to overheat. Conversely, if all sectors taken together aim to run a financial surplus, i.e. want to spend less than their expected income and use the difference to pay down debt ?the economy will tend to operate below potential.
We can illustrate this point using some simple assumptions. First, we assume that the current account is fixed at a deficit of 3% of GDP. This is a big simplification, but it does capture the fact that at least some of the factors causing a retrenchment in the United States are also causing a retrenchment in other countries that experienced a credit bubble.
Second, we assume that the public is uncomfortable? or Congress believes that the public is uncomfortable? whenever the general government deficit is above 7% of GDP. While larger deficits are possible for short periods of time, Congress ultimately responds to them by cutting spending and/or raising taxes. The precise number is obviously arbitrary, but we do believe that there is a level of government deficits beyond which the political demands for retrenchment become difficult to resist.
These assumptions imply that the private sector cannot aim to run a financial surplus of more than 4% of GDP without sapping aggregate demand. This is a serious problem because our analysis a few weeks ago concluded that the private sector may target a financial surplus of significantly more than 4% of GDP for the next few years in order to reduce its debt burden at an acceptable pace. This point is illustrated in Exhibit 3. The top panel shows the ratio of private sector debt to GDP, while the bottom panel plots the change in this ratio against the private sector financial balance. The point to note is that large surpluses are likely to be necessary in order to bring the private debt/GDP ratio back to historically more normal levels. In fact, even if we assume? highly optimistically? that the private debt/GDP ratio only needs to return to the upward sloping trend line seen since the 1950s over a five year period, the private sector balance may need to stay near the current 7% of GDP level for the next five years. In fact, we believe it is likely that the private debt/GDP ratio will need to decline to a level well below the prior trendline, although the extent of this decline is difficult to estimate with any degree of confidence.
So what happens if the private sector indeed wants to run a 7% of GDP surplus? This means that on an ex ante basis, spending will fall short of (expected) income by 3% of GDP. This demand shortfall saps production, and consequently the income from production. As a result, private sector income is lower than expected, which pushes the private sector balance below 7% of GDP (i.e. to a ?looser? position than desired by the private sector) unless there is a further downward adjustment in private sector spending.
Moreover, lower private sector income implies lower tax revenues, which has a similar impact on the government balance and could trigger further austerity moves by Congress. Ultimately, this adverse feedback loop doesn'?t end until someone accepts a smaller surplus or a larger deficit.
Hatzius then muses on what the possible responses to this imminent economic contraction are, on either the fiscal or the monetary side, and to the chagrin of Keynesianites, finds no feasible options.
The Response of Fiscal Policy…
Let us suppose that we are in the situation outlined at the end of the previous section. What can policymakers do?
In the context of the financial balances framework, the most straightforward response is to boost aggregate demand by targeting a government deficit of at least 10% of GDP?indeed, a bigger target would be better because a period of sharply above-trend growth would be highly desirable to fill in the economy?'s large output gap.
The main objection to such a policy is that higher public deficits raise the risks of a public debt crisis of confidence. Our own view is that these risks have been exaggerated, at least in the case of the United States. Public debt and especially public debt service are still at moderate levels, and the bond market is showing few signs of discomfort with the US fiscal outlook. Moreover, as a practical matter it is in any case difficult to avoid large deficits as long as the private sector is retrenching and the current account is in deficit. As already noted, this saps revenue growth. So it is better to accept the need for these deficits on an ex ante basis since, to a large extent, they will happen ex post anyway.
Nevertheless, we do recognize the difficulty of implementing large-scale fiscal expansion over an extended period of time. Even though we and many others have presented compelling (we think) evidence that last year?s fiscal stimulus package has helped the economy, polling evidence suggests that the public does not buy this; for example, in the most recent Pew Research poll, only about one-third of respondents thought that the stimulus package had ?helped? the economy. Evidently, it is difficult to persuade voters that running large-scale public deficits at a time when many are cutting back in their personal lives is a good idea. If so, the idea that policymakers can offset whatever restraint is coming from private sector retrenchment by ramping up the fiscal stimulus may be sensible economically but unrealistic politically.
One way to make meaningful near-term fiscal easing more acceptable might be to couple it with longer term fiscal tightening. This would argue for a plan to ease the near-term fiscal stance via extensions of unemployment insurance (again), aid to state governments, and the bulk of the 2001/2003 tax cuts (temporarily)?perhaps along with a payroll tax holiday?but couple this with legislation to slow the growth of spending and raise direct and indirect taxes 3-5 years in the future. Another (theoretical?) possibility is to make future tax hikes explicitly conditional on the cyclical position of the economy, perhaps simply measured by the level of the unemployment rate and/or inflation.
…and of Monetary Policy
If these options are out of reach and fiscal policy therefore remains too tight, the alternative is further Fed easing. But even under normal circumstances? that is, if the funds rate has not yet hit the zero bound?its impact in the simple financial balances framework described above is less direct than that of fiscal policy. The main impact of monetary policy on ex ante financial balances is that lower interest rates and/or easier credit in some other form aim to entice the private sector to borrow a little more, or at least to stretch out its retrenchment out over a longer period. But when the channels of credit intermediation are impaired and the private sector has decided to reduce its debt loads, it may be difficult to make as much difference as normal via monetary policy.
These difficulties are magnified in the current environment, where the funds rate is bounded at zero. Fed officials have managed to ease financial conditions by backstopping the financial system and purchasing mortgage-backed securities, and this has probably limited the extent of the private-sector retrenchment to some degree. But our analysis suggests that the total impact has been only equivalent to a 70-basis-point cut in the federal funds rate target. This small a change is unlikely to reverse a fundamental move toward financial restraint and balance sheet repair.
So what else could the Fed do? One option is ?more of the same ??an even more explicit commitment to low rates, a further small cut in the interest rate on excess reserves (IOER), or additional asset purchases. However, while this would undoubtedly ease financial conditions a bit more, it is hard to believe that the impact would be very large unless the asset purchases were very aggressive. One potentially more powerful option is the adoption of a significantly higher inflation target, as suggested by a number of prominent academic macroeconomists. If such an announcement is credible, it could increase inflation expectations and reduce real interest rates. This could lead the private sector to slow down its retrenchment?i.e. cut the ex ante private sector surplus ?and thereby provide a boost to growth.
However, one important reason for why Fed officials have not shown any signs that they are actively considering such a policy is that it risks increasing inflation risk premia as well as inflation expectations. While higher inflation expectations lower real interest rates?defined as nominal rates minus expected inflation?and are generally welcome at a time of significant deflation risks, a higher inflation risk premium would offset that by raising real interest rates and tightening financial conditions. It is therefore not surprising that Fed officials have so far eschewed any discussion of a higher inflation target, although this could change as inflation declines further.
Jan's conclusion is brief and to the point: the days of deluding ourselves things are getting better, are rapidly coming to an end.
The upshot of our discussion: given the forces of retrenchment and balance sheet repair, the risks to the growth of aggregate demand? as well as risk-free interest rates?over the medium term are tilted to the downside. Policymakers can provide some relief, but realistically will find it hard to neutralize the headwinds altogether. Thus, the risks to growth over the medium term are clearly tilted to the downside.