Barack Obama has made his truce with the changed mood in the Congress and decided to extend the Bush tax cuts for two more years. Democrats wanted him to extend all tax cuts except the top income brackets above $250,000. The Republicans threatened a meltdown since after January they will have a majority in the House and Democrats will not be able to break a filibuster in the Senate. Obama saw the beauty of expediency and extracted a payroll tax- a boon to the middle income earners in exchange.
Purists like Paul Krugman wanted Obama to stand firm, and threaten that if the Republicans did not give him the tax cut except for the top slice he would let the tax cuts expire. That would mean higher taxes for everyone. That would be a principled stand. But while this is redistributive, it is also deflationary. The fragile recovery in the US would be reversed and a double -dip recession will no doubt be the result. What is more, the voters would not blame Congress; they would blame Obama and he would have to kiss a second term goodbye.
Politics is like that. It does not afford first-best solutions and often not even second-best ones. Obama has secured a fiscal boost without having to pass a Bill. That is the best he could hope for. But this also means that the US deficit will rise and the debt/GDP ratio will definitely get worse. The markets saw this immediately and so the yields on US bonds went up.
Obviously, the solution of the debt burden is left for another term or for (more realistically speaking) another President. The hope must be that growth will pick up, thanks to the tax cut being continued. That would reduce welfare expenditure and ease the budget deficit.
This is a delicate tradeoff. Keynesians would, of course, prefer a spending boost with a tilt towards those who are lower paid. This would increase the deficit but may also have a larger multiplier effect. However, political economy has intervened to make for tax cuts for the higher earners instead and one has to live with that.
The strange thing is that in Europe there seems to be no taste for such spending or tax cuts. Europe is into debt reduction, with a drastic cut in government spending. First it was Greece and then it was Ireland that faced serious attacks from the market, where the debt has had to be serviced with a higher interest rate. The contagion is likely to spread to Portugal and Spain as well. Note that these two governments have already cut their budgets drastically. Similarly, the UK has embarked on a strict programme of reducing the deficit to zero over five years from the current level of 11% of GDP.
What explains this contrasting approach to the recovery? The US is being Keynesian while Europe is being very classical. The Eurozone countries have, of course, signed up to an orthodox budget stance with a targeted limit of budget deficit being less than 3% of their GDP. However, the Eurozone countries cannot devalue nor can they pursue quantitative easing individually. After all, they have no degrees of freedom whatever. But the Eurozone, instead of offering them protection, has actually burdened them with extra costs. There is now, belatedly, a stabilisation fund.
But to apply for this fund is an admission of failure and really alarms the markets.
The Eurozone crisis has made it clear that there are no risk-free sovereign debt issuers. Governments can default, will default and indeed in case of Greece and Ireland ought to default if they do not want to sentence their people to untold misery. Debt holders? sentiments always command respect in financial markets but sovereign debt issuers have other responsibilities, namely to their citizens. Those who buy sovereign debt ought to factor in all this or lose their money. In a globalised world, sovereigns are players just like all others in the global financial markets.
The US?s is a different case and this is due to the dollar being a reserve currency. The euro began to be a substitute in many central banks but now it has taken a back seat. The RMB is not yet available for these purposes, though the Chinese are experimenting with a RMB bond in the Hong Kong market. The US markets are deep and highly liquid. This is a strong reason for people to hold on to US debt since they can always sell it. The US, therefore, enjoys a seigniorage advantage. This allows the US fiscal discipline to be looser than elsewhere.
This advantage, however, is a mirage. The longer-run trends are that the US and other OECD countries are losing their growth momentum and the emerging countries of Asia, Latin America and Africa are speeding up. Eventually, capitalism demands high savings and high investments, innovations and rising productivity to generate higher growth. Financial manipulations offer short-run gains. Keynesian ditch-digging is only a temporary palliative. The world, in the long-run, is classical. Even sovereign debt has to be paid back in real resources and not in funny money.
The author is a prominent economist and Labour peer
