The politics of debt – why overcoming structural deficits might be both easier and more difficult than generally assumed

debt word collageOver the past few years, it seems that politicians have suffered an important loss of independence. Instead of displaying leadership and shaping economic policy, they are being chased by “the markets”. Central banks around the world have heeded politicians’ calls for help and reduced interest rates to historic lows. Nevertheless, growth remains slow, unemployment high, and investors nervous.

Not least in Europe, governments and the European Central Bank (ECB) outbid each other in their efforts to contain market fears and return the common currency to stability. It took no less than Mario Draghi’s announcement of the ECB’s “Outright Monetary Transactions Program”—the ECB’s commitment to buy unlimited government bonds on the secondary market—to break the vicious circle of spiraling government debt and bank rescues. Investor fears remain, however: Cyprus’ bailout in March this year warrants further caution on this front and when the Federal Reserve recently hinted at a possible end of Quantitative Easing next year, stock markets fell.

The reasoning underlying loose monetary policy in the current crisis is based on solid economic theory and most economists agree—at least in principle—that this approach is right. Similarly, all rescue measures following the initial Greek bailout certainly prevented a dangerous domino-effect. However, government bail-out packages in the Euro area, central bank bond-buying programs, and low interest rates share a common feature: they merely deal with problems in the short-term.

At first, this does not seem like a revolutionary statement—most economists will reply that monetary policy obviously only affects the short run and politicians will maintain that they are well aware of the need for structural reform. After all, long-term reforms require time to take effect; loose monetary policy, bailout and bond-buying programs are therefore dictated by current circumstances without leaving much room for alternatives. To a certain extent, this is true and in this sense, politicians and central bankers are merely reacting to the crisis. However, this story suffers from two oversimplifications.

First, it neglects the effect of short-term relief on politicians’ incentives to tackle long-term problems. Decision-makers have to strike a balance between the costs of reform and the costs of inactivity. On the one hand, implementing painful budget cuts and structural reforms that lower real wages and pension benefits creates discontent and therefore cost governments their popularity and votes. On the other hand, the immediate crisis results in political pressure that requires a reaction and the provision of solutions by politicians. By nudging central banks to loosen monetary policy and providing short-term relief in the form of rescue-packages, governments can avoid costly structural reforms while displaying activity and reducing popular pressure. The result is that—although economically sound—short-term relief might actually harm the process of necessary long-term structural reforms by reducing politicians’ incentives to implement it.

Second, the story ignores the immediate positive effects that the adoption of long-term reform measures can have. The reason why the Eurozone had to adopt several subsequent ultima ratio rescue packages is that the governments never provided a credible roadmap for sustainable reform of their public finances. Similarly, postponing decisions about the public pension reforms and other demographic challenges creates uncertainty in the business environment which severely reduces private investment.

The point here is that the way out of the current economic crisis lies in the adoption of both short-term and long-term measures. The rationale should be that a real solution is the adoption of structural reforms and the reduction of structural budget deficits. A simultaneous loosening of monetary policy together with emergency provisions for the stabilization of the financial sector are equally important, but they merely buy time for the former to take effect. While a tendency to myopic economic policy represents a systemic difficulty of any democratic system, more weight should therefore be placed on the benefits of reducing political window-dressing and increasing transparency and accountability in economic policy-making. If politicians stop blaming the markets for being suspicious of their policies, they can co-opt them and thereby regain control of the situation.

 

By: Marvin Gouraud

Sources: European Central Bank, Journal of Economic Policy Reform, The Economic Journal, Critical Review, The Wall Street Journal, Journal of Public Policy, Capital Markets Law Journal, Business Week, Council of the European Union, The International Spectator

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U.S. Debt Now Over 100% of GDP – Corporate Leaders Weigh In

With the U.S. government continuing its deficit spending this year, estimated at $1.1 trillion by the Congressional Budget Office, the U.S. debt inches closer to the $16.4 trillion debt ceiling agreed on by Congress in July 2011. According to recent data released by the Treasury Department, the government surprisingly ran a surplus of $75 billion in September. Despite September’s anomaly, the federal debt ceiling is projected to be reached by January 2013.

Last Monday corporate leaders of some of the biggest companies in the U.S., members of a campaign called “Fix the Debt”, urged Congress to come up with plans to alleviate the nation’s growing debt problem. The solution: Increase taxes for the wealthy and cut federal benefit programs such as Medicare and Social Security. The proposed measures go directly against what either party desires. Democrats look to maintain spending on social programs while Republicans want to keep the tax rates for wealthy Americans at current levels.

Austerity seems to be the only way to dig the American economy out of this hole. Robert Greifeld, chief executive of stock exchange operator Nasdaq OMX Group Inc, told a Bloomberg Television roundtable that everyone is going to have to take part in the recovery, noting that, “there has to be shared pain.” Scott Davis, CEO of United Parcel Service Inc., agreed with the sentiment expressed by Mr. Greifeld.

At some point, the growing debt problem facing America has to be dealt with. Historically, the debt as a percentage of GDP rose to an all-time high at the end of World War II when it stood at 126%. After slowly decreasing to a low of 33% in 1981, the debt has been steadily increasing for the last three decades. The consequences of America’s debt problem have repercussions for the entire global economy, slowing down world commerce. At home, racking up more debt puts more pressure on future generations of Americans to solve the problem.

There is a growing concern about the debt among CEOs. Steven Rattner, head of Willett Advisors LLC said that “for the first time, there is tremendous support in the business community even if it isn’t exactly what everyone in the business community would want to see”. With more CEOs emphasizing the need for a solution, the prospects of turning the tide become brighter. How the debt problem will be dealt with remains uncertain – many factors, such as the outcome of the election and the raising of the debt ceiling play a big role. What is certain as of right now is that the US debt problem is bigger than it has been for more than sixty years.

Posted by: Samuel Benka

Sources: The New York Times, The Wall Street Journal, Reuters

Photo Credit:Fix the Debt News Conference Courtesy of Flickr user Talk Radio News Service

Is higher education the next financial bubble?

Rumors have been circulating over the past few months that higher education is the next financial bubble, and now it looks like it could be bursting. Student and institutional debt has soared into the trillions of dollars, making student debt the number one consumer debt in the nation.  President Obama has called on state governments to invest more in public higher education since state support of public universities is at its lowest (per student) in 25 years. Although public institutions are facing the challenges of slashed budgets, is public high ed too big and too important to fail?

The federal student loans of today are very different from what they used to be. According to The Project on Student Debt, 37 million current and former students owed upwards of $25,000 each in student debt in 2010. And interest is set to double on federally subsidized student loans from 3.4% to 6.8%. And finally, to make matters worse, most students cannot free themselves from excessive debt through bankruptcy thanks to the almost impossible to fulfill “undue hardship” clause of the Bankruptcy Code.

For financial experts, the higher education debt situation looks like a textbook financial bubble: “easy credit, the accumulation of excessive debt, the bubble stops growing, borrowing becomes harder.” And it seems that the nation’s lenders are moving colleges and universities into the second half of the timeline. US Bank recently announced that it “will no longer be offering private student loans” and JPMorgan Chase has stated that it will only continue its lending to established customers. Financial experts are saying that this shift in lending policies is “an early warning that the party is almost over.”

In response to this looming crisis, the Chancellor of UCLA has suggested that “instead of more cuts, we need an emergency plan to rescue and revitalize our public higher education system.”

Posted by: Devon Thorsell

Sources: Huffington Post, Richmond Times- Dispatch, Benzinga

Photo credit Harvard University Building courtesy of flickr user Lori SR