The past couple of months have seen the emergence of a surprising new internet music hit. The hit in question is a rap entitled Fear the Boom and Bust and is sung by the impersonation of two enigmatic and yet celebrated economists: John Maynard Keynes, and Friedrich Augustus von Hayek. As far as rap goes, the composers John Papola and Russ Roberts’s choice of topic was also uncommon. Instead of singing about voluptuous women or drive-by shootings, Keynes and Hayek rap about the mechanics behind the interaction of economic cycles with counter-cyclical policies.
Interestingly, Fear the Boom and Bust does something that many economic pundits have failed to achieve so far. It efficiently identifies the next phase of the crisis, a phase surely less theatrical than failing investment banks and insurance companies, but potentially as damaging: a decade-long sluggish economic performance created by burgeoning public deficits and inflationary pressures.
In the US, the budget deficit reached 9.9% of GDP and is expected to reach 10.6% in 2010, the highest figures since WWII. The IMF puts the fiscal deficit at 13.6% of GDP in 2009, 9.7% in 2010 and 4.7% in 2014. The Congressional Budget Office has estimated that, in the next decade, the fiscal deficit will amount to US$ 7.14 trillion. Public debt will likely rise from 54% of the GDP in 2009 to 68% in 2019. Close inspection of the American budget forecast, however, shows that little real effort has been put in reigning in the rapidly growing public deficit and debt. Some European countries such as Spain, Britain, and Greece are in no better shape with budget gaps of 11.4%, 14.2% and 12.7% of GDP in 2009 respectively.
Although already in a slight upward trend, spending only skyrocketed in 2008 as governments saw themselves forced to bailout troubled financial institutions. As the financial crisis spread to the real economy, production fell and unemployment rose. This was the opportunity for New-Keynesianism to test their theoretical developments of the last 20 years. The gist, however, has remained basically the same from the 1930s—boost aggregate demand.
At the time, without the benefit of hindsight, the prospects of falling dominos in the financial system was certainly scary enough to tone down any ideological bickering. This regardless of their analytical validity. As Ben Bernanke, Chairman of the Federal Reserve wisely put it: “there are no atheists in fox holes and no ideologues in financial crises.”
Much like in the Great Depression, however, the outcome of these policies has been a rapid expansion of public debt. Trillions of dollars were added to public debt by the implicit government guarantees to mortgage lenders, the off-balance sheet transactions carried by the Fed and central banks throughout the world, and the lax fiscal policies included in most stimulus packages. Furthermore, in contrast to the situation observed in most GCC countries, spending has been financed overwhelmingly by deficits and debt in most western and emerging economies. Given that debt levels were already high, this trend may prove extremely costly in the future for the world economy.
The main problem with debt financed stimulus programs is that a debt level that is manageable for a given market interest rate, tax revenue, and economic growth projections may not remain manageable in the event of an external shock. In order to take advantage of lower interest rates, governments often opt for short-term debt issuance. When these debts come to maturity, lenders roll over the principal into another short-term contract. This mechanism works smoothly up to the point where it no longer does. If market confidence erodes too much, lenders may decide not to roll over government debt, precipitating a crisis.
Even though Credit Default Swaps (CDS) spreads have increased considerably in the aftermath of the crisis, considering a possible massive government default by the US and the major members of the European Union may be ludicrous given the extremely high incentives for creditors not to let this happen. This is unfortunately not the case of Portugal, Italy, Greece and Spain—revealingly known in the public debt market by the acronym PIGS. Such defaults—which include substantial debt rescheduling and restructuring—would prove devastating for the EU and the global economy.
But this is not the end of the story.
Historically, countries have used subterfuges in order to avoid overtly defaulting on their public obligations. Since the advent of fiat currencies, governments have often resorted to a sadly efficient way of facilitating the repayment of their obligations: inflation.
Keynesian economic policy already almost invariably leads to higher inflation since higher government expenditures increase demand and, therefore, prices. As the economist Robert Barro famously concluded in 1974, however, these policies only work if economic actors are unable to anticipate future inflation rates. Using the Ricardian Equivalence, Barro explains that consumers do not spend the additional post-taxes income created by lax fiscal policies because they realize that higher taxes in the future are required to pay the debts created by the fiscal stimulus.
The main problem with Keynesian policies is that since the inflationary policies of the 1970s, economic actors have been well trained to predict future inflation rates created by government expenditures. This considerably reduces the short-term efficiency of these policies. What economic actors have been less well trained for, however, is to predict inflation rates stimulated by burgeoning government debts. Given the striking lack of transparency in public debt levels, this is not all that surprising.
In this context, the prospect of medium run economic performance in western countries is rather lacklustre. Inflation causes distortions in the economy and particularly so in the banking system and financial sector. It is safe to say that governments will not pursue aggressive inflationary policies, notably, because of the aforementioned costs. It is also safe to say, however, that the artificially lowly held interest rates are bound to create over investment in low return capital assets. When interest rates go back to their equilibrium levels another bubble is likely to burst.
Daniel Capparelli
