A radical exit from global financial crisis

Even with stimulus programs, bank bailouts, quantitative easing and more, neither the US, Europe or Japan are escaping their financial gloom. But there is another solution.

The most remarkable feature of the global financial crisis is its sheer duration. For five years now, developed economies have been in trouble – much longer than ‘ordinary’ recessions usually last. This is despite bountiful attempts to return the world’s industrialised economies to their previous steady growth path.

Yet even with stimulus programs, bank bailouts, quantitative easing and a host of other government activities, neither the US, nor Japan and least of all Europe are escaping from their economic, financial, fiscal and monetary troubles. In many countries, there is talk of a ‘double-dip’ recession (with a ‘triple dip’ presumably just behind the next shallow recovery) or the prospect of a ‘lost decade’ or two la Japan.

It must be an immensely frustrating experience to be a dovish central banker or a Keynesian economist in these circumstances. Central banks have been flooding markets with fresh and cheap money – to no avail. Despite all the talk of austerity, many governments have increased their deficits in the crisis – and the economy has barely budged. The ordinary responses to ordinary recessions simply do not work in these extraordinary times.

Of course, if you had advocated such policies before and now see that they do not work, you could argue that they have been applied too timidly. If monetary policy had provided even more stimulus, and if deficit spending had been even more pronounced, then everything would have been fine. Though one can occasionally hear such statements, even from Nobel Prize winning economists, they sound a bit like communism’s apologists: If only it had ever been tried correctly!

But perhaps all these calls for stimulus, money printing and deficit spending have been completely misguided from the outset? Maybe something else should have been tried altogether?

This is the core argument of star economist Vito Tanzi. In a short pamphlet just released by British think tank Politeia, Tanzi argues that Keynesian solutions to the economic crisis do not work and that radical reductions in government spending coupled with far-reaching structural reforms are the only realistic answer.

Tanzi’s academic qualifications are impeccable. With a PhD from Harvard, honorary degrees from universities in four countries, countless awards, and even an economic effect named after him, he is one of the world’s most distinguished experts on public finance.

However, Tanzi is not just an excellent academic but also an experienced practitioner. He served as director of the Fiscal Affairs Department at the International Monetary Fund for nearly two decades and also as State Secretary for Economy and Finance in the Italian government from 2001 to 2003.

In his Politeia pamphlet ‘Realistic Recovery – Why Keynesian Solutions Will Not Work’, Tanzi explains that there are only three ways in which heavily indebted countries could manage to get their budgets back in order. Unfortunately, one of them relies on the supernatural, one does not work, and the remaining one is tough and painful.

The supernatural solution to the crisis is to do nothing and wait for economic growth to return by magic or good fortune. If only growth resumed and filled finance ministers’ coffers, public debt would shrink over time and the world would be saved. Unfortunately, there is no realistic hope for such an economic miracle to happen. And even if it did, the rising interest rates in an economic boom would make it even harder for governments to pay down the massive debt burdens they would have accumulated by then.

The second solution to the fiscal crisis is to try to stimulate the economy through additional fiscal and monetary measures. Tanzi does not believe this could work, either. He drily comments, "if fiscal deficits as high as ten per cent of GDP in some countries including the US and the UK have not done the trick, it seems improbable that even higher deficits would have the hoped for effects on their economies.” He also contends that rising deficits would further unsettle financial markets and thus turn out counterproductive.

This leaves only the third solution, which is painful but according to Tanzi the only realistic option. Governments in high deficit/high debt countries would have to reduce their spending dramatically while reforming their economies to make them more flexible and conducive to growth.

Tanzi’s recommendation goes well beyond the calls for austerity, which is usually a temporary measure to calm fickle markets. What Tanzi has in mind is something completely different.

Contrasting low-spending governments such as Australia and Korea with high spending ones like France and Italy, two things are obvious. First, the difference in the size of the state can be as large as 20 percent of GDP. But second, there is no corresponding difference in the provision and quality of public goods.

As Tanzi has repeatedly argued in his academic publications, from a government spending ratio of around 35 per cent of GDP, additional government spending generally does not yield any marginal social effects. If that is the case, so he argues, why should countries spend 45 or 50 per cent of their economic output on public services and redistribution? Instead they should drive down their spending to the levels of the lowest spending developed economies.

To achieve these reductions, Tanzi believes it is inevitable that some public services currently provided by governments in high spending countries will be supplied by private service providers in the future. In this way, they could be delivered in a more competitive environment which would reduce the cost to taxpayers.

If Tanzi’s considerations sound like pipedreams, it is worth remembering that the alternatives to his strategy have all been tested – and failed. ‘Do nothing’ is not an option unless you believe in divine intervention; stimulus aggravates the public debt problem while only creating flash-in-the-pan growth effects.

Once it is finally realised that this economic crisis is not an ordinary recession, perhaps we will stop deploying Keynesian remedies and begin more fundamental reforms as advocated by Tanzi. But then again, it took several decades until communism’s apologists ran out of excuses – and some are still at it.

Dr Oliver Marc Hartwich is the Executive Director of The New Zealand Initiative. Vito Tanzi will be speaking at functions in Auckland and Wellington on August 21 and 22. Tickets are free but registrations are essential.

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