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Opinion

Against the tide: Returning to normal

GDP growth must be sufficient to outweigh possible deleterious effects of sovereign budget cuts and measures to increase revenues. It’s an impossible ask for Japan and an extremely tough one for the eurozone.

Without economic growth – in particular, nominal growth – the global sovereign debt crisis cannot be overcome and public finances cannot return to normal. To achieve sufficient nominal growth to get debt ratios down will require that central bankers ensure negative real bond yields and allow higher inflation.

A return to normal means a return to fiscal and sovereign debt orthodoxy in the three main economic blocs (the eurozone, the US and Japan).

It is no wonder that markets have taken the sovereign debt crisis to heart. The only way for governments to deleverage is to make the private sector pay for it. In many places that creates the double jeopardy of private-sector and public-sector deleveraging at the same time. That’s the backdrop. It is a big challenge to economic growth.

But what sort of growth? Nominal, not real, GDP/GNI growth is in practice the key to debt sustainability. Budget austerity will be delivered in most places in one way or another. But unless the debt-to-GDP ratio is reduced by growth (ie, a rise in the denominator), sustainability will never come. And nominal growth is what brings in the taxes that can turn the fiscal back to normal.

Also, we now know that central bankers can control bond yields to a great extent by buying bonds of longer maturity. The central bankers can even keep the real bond yield negative. What that means is that it is feasible to incorporate higher inflation into nominal GDP growth, but prevent it from affecting the cost of sovereign debt.

Growth to stabilize sovereign debt

Nominal GDP growth of the principal economies

Source: Datastream


Of course, such distortion of the pricing of risk and the resultant misallocation of resources will come at a high economic cost in terms of the underlying productivity of an economy over time. But for the immediate future, central bankers can help restore debt sustainability by reducing the nominal interest rate on sovereign debt below the nominal growth rate of the economy. Then there is what can be called the stall speed of the economy. That’s the point at which fiscal austerity produces bigger budget deficits and debts because the impact on growth outweighs the benefits of budget spending cuts and revenue measures.

At a rough guess, the stall speed for Japan is about 3% nominal growth, Europe is 4% to 5% and the US something similar. At growth rates below this stall speed, budget austerity fails to produce debt stabilization. Indeed, it has the opposite effect.

Japan has no hope of exceeding its stall speed in the next decade. Elsewhere, to achieve growth in excess of the stall speed, 3% to 4% inflation is going to have to be tolerated and encouraged in both the US and the eurozone. So interest rates on sovereign bonds are going to have to be wrestled to the floor by compliant central bankers.

The US might not have a problem with this. The European Central Bank surely will. The ECB might be forced to bend eventually. But that will be on the other side of a crisis forcing it to do so. Next year is critical, because if we get to 2013 with eurozone nominal growth still below the stall rate then, by definition, the sovereign debt crisis will still be getting worse, not better. And the European leaders will have spent all of their designated reserves on bailouts by then.

Markets are focused on whether Greece will default before the eurozone’s emergency financing mechanism, the EFSF, gets new powers and resources this month. And EFSF resources still have to be raised to as much as €1.6 trillion to get the eurozone to 2014 in one piece.

The real big issue is that Europe is likely to remain below the nominal GDP growth stall rate, causing the fiscal arithmetic behind the crisis to get inexorably worse rather than better.



David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com

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