Stimulating debate

The markets, and developed economies, are too dependent

on government action
Feb 4th 2010 | From The Economist print edition

Illustration by S. Kambayashi

AS JANUARY goes, so goes the year. That old stockmarket saying does not augur well for
2010, given that the MSCI World index fell by 4.2% in the month, the biggest decline since
February 2009, and emerging markets dropped by 5.6%.

Although markets rallied a bit in early February on better-than-expected economic data, the
poor start to the year reflected an inherent contradiction to the rebound of 2009. That rally
seemed to be dependent both on extraordinary stimulus measures by governments and central
banks, and on a vigorous economic recovery. But both cannot co-exist for long: either the
recovery will not last or, if it does, the stimulus will be taken away.

In addition, governments’ ability to provide that stimulus is dependent on the markets’ own
willingness to fund huge deficits at very low yields. But why would investors accept meagre
yields if they expected a vigorous recovery? In a sense, the market seemed to be hauling itself
up by its own bootstraps.

Sure enough, the bullish story has started to unravel, if only at the edges. In the developing
world China has attempted to tighten monetary policy. That has caused some alarm because
China was acting as the engine of global growth.

And in the developed world investors have started to question the ability of governments to
keep financing their deficits. The obvious example is in Greece, where ten-year bond yields
reached 7% late last month. At that level, which is well above likely Greek GDP growth, the
country’s indebtedness would grow very rapidly. However unpopular it may prove to be, an
austerity package is needed to prevent Greece from falling into this debt trap (see article).

So even in places where governments may wish to maintain fiscal stimulus, the markets may
force them into corrective action. Britain, France, Ireland, Spain, Portugal and others have all
indicated their determination to keep deficits under control, with varying degrees of
conviction.

But withdrawal of even small parts of the stimulus packages can send an economy back into
the doldrums. As an example, American new-home sales slowed sharply after an initial end-
of-November deadline for the expiry of a buyers’ tax credit. Although the credit has since
been extended until April, December’s sales were just 342,000, compared with 329,000 in
January 2009, at the height of the crisis.

The stimulus may have prevented the global economy from slipping into depression. In the
medium term, however, academic studies suggest that higher government spending leads to
slower economic growth. A 2008 paper by Antonio Afonso of the European Central Bank and
Davide Furceri of the University of Palermo calculates that for every one-percentage-point
rise in government spending as a proportion of GDP, the growth rate falls by 0.12-0.13
percentage points.

What’s more, the packages have not really dealt with the problem of excessive debt, but
merely transferred it from the private to the public sector. This buys time, but is akin to those
debt-consolidation plans that are sold to consumers on TV. The pain is spread out over a
longer period. But pain there will be, in the form of higher taxes, higher bond yields, slower
growth or a combination of all three.

The authorities face a dilemma. Reduce the stimulus now and they risk plunging the economy
back into recession, as happened in America in 1937 and Japan in 1997. But leave the
stimulus in place for too long, and they risk damaging long-term growth prospects.

The bulls hope that the economy can escape from this trap by the simple expedient of private-
sector growth. That is why they welcomed the rise in manufacturing activity signalled in this
week’s latest purchasing managers’ indices. If the private sector rebounds of its own accord,
unemployment will fall and budget deficits will decline.

But hopes for a strong private-sector recovery are undermined by the data on credit growth. In
the year to December, the broad measure of money supply fell by 0.2% in the euro zone and
grew by just 3.4% in America. In Britain the annual growth rate is higher (6.4% in
December), but David Owen, an economist at Jefferies International, estimates that
quantitative easing (QE), whereby central banks create money to buy assets, has been
boosting the figure by an annualised rate of 10%. If the Bank of England stops QE entirely,
the credit-growth rate could collapse. For the stockmarket rally to resume properly in 2010,
economies in the developed world need to show they can stand on their own two feet.