FISCAL STIMULUS AND SOVEREIGN DEBT: A POLICY DILEMMA (TheSkepticalMarketObserver)

SATURDAY, JUNE 19, 2010

FISCAL STIMULUS AND SOVEREIGN DEBT: A POLICY DILEMMA

In my last post I stated the paradox that the growth of the Welfare State, so closely related to the spread of the Keynes’ ideas, has sapped the potency of Keynesian fiscal stimulus. Keynesian economics can more readily stabilize the classical night watchman state than reverse a downward spiral of the mixed economy. 

In this post, I examine the dilemma of using policy to stimulate our (US and European) economy. Private spending has declined and private saving has increased dramatically since the financial meltdown of 2008. In order to counteract its contractionary force, Keynes prescribed that government dis-save and spend more, which increases government debt. At any level of debt, the probability of default rises with the size of debt and declines with economic growth. 

The Dilemma

The dilemma is this: Fiscal stimulus spurs growth, which improves the capacity of government to service debt, but also increases debt, which in extremis can push up default risk to a point where private agents will not lend to government. At that point fiscal policy breaks down. The higher the initial debt, the more dominant will be the latter effect. So, push on the fiscal lever and risk a government debt crisis or lay off it and risk stagnation, and the possibility of a government debt crisis. Greece has passed the tipping point. Much of the rest of Europe is near and nobody can be sure how far away is the US.

Keynes famously satirized the British government in depression: “They say they cannot spend because they do not have the money, but they have not the money because they will not spend”. But the UK did not face a borrowing constraint in the 1930’s. It may be near one today.

As I pointed out in my last post, this argument is not founded on any notion that government debt ‘crowds out’ private investment when the economy is in a slump. It accepts the idea that a market economy can be stuck in a position of low capacity utilization. Even so, people will not lend to a sovereign they fear will default.

Some commentators, notably Paul Krugman, will not countenance that we may be near the practical limits of government debt capacity. His sanguinity is contradicted by the historical record of sovereign default in the wake of financial crises. 

FULL POST HERE