Brian Fallow: Opinion split on how to ditch debt

The debt taken on by households during the last boom and by governments during the subsequent crisis and recession is going to weigh on Western economies for years to come and one way or another slow them down.

At the weekend the G20 sought a middle way between the risk of derailing an "uneven and fragile" global recovery and dealing with the rapidly deteriorating fiscal position of the major developed economies.

Squeezing between that rock and that hard place they came up with a pledge to at least halve fiscal deficits by 2013 and "stabilise or reduce government debt-to-GDP ratios by 2016".

New Zealand is not a member of the big boys club of course but on Budget forecasts would meet those targets - just.

The case for what might be called the fiscal disciplinarian's view was laid out trenchantly by the Bank for International Settlements, the central banks' central bank, in its annual report released this week.

It projects gross government debt for the advanced economies as a group to top 100 per cent of GDP next year, up from 76 per cent in 2007.

It is not just the level that is of concern. It is the speed with which it is rising, in other words the size of the deficits. The increase in the gross debt ratio has risen from 76 to 100 per cent in just four years, compared with the 40 years it took to rise from 40 to 76 per cent.

The projected deficits for Britain, the United States and Japan are 10, 9 and 8 per cent of GDP respectively and their gross government debt 91, 95 and 205 per cent respectively.

And all of this is happening as burgeoning healthcare and pension costs of an ageing population loom ever larger on the horizon.

High levels of public debt are problematic in several ways.

The associated interest costs crowd out more productive uses of the taxpayer's dollar, like spending on education, health and infrastructure.

It competes with the private sector for the investor's dollar. That competition, with premia for a higher risk of default or inflation, could push up interest rates and constrain business investment.

It also reduces the ability of governments to respond to future shocks in the way or to the extent they were able to when the global financial crisis hit.

The BIS says the evidence on the implications of high levels of public debt on economic growth, while slim, suggests they could be significant.

Among countries which have a debt-to-GDP ratio of more than 90 per cent, the median GDP growth rate is 1 percentage point lower than in countries with a lower debt ratio.

It also cites work by economists Kenneth Rogoff and Carmen Reinhart which suggests the expected rise in the debt-to-GDP ratio in advanced economies over the 2007 to 2015 period might permanently reduce their potential growth rate by more than half a percentage point a year.

High public debt has implications for inflation and interest rates too.

It increases the temptation to tolerate higher inflation to reduce the real value of the debt.

This does not eliminate the burden. It merely redistributes it to those with least economic power.

The cost of yielding to that temptation to try to "inflate the debt away" includes persistently higher real interest rates, the misallocation of resources, and the cost in jobs of eventually bringing inflation back down again.

Sensitivity to these dangers makes for an environment in which it would be risky for New Zealand - abjectly dependent as it is on importing the savings of foreigners - to be seen as abandoning an orthodox monetary policy framework. Labour's proposed changes must therefore be judged against the Hippocratic test: First, do no harm.

Not everyone agrees with the stance of the fiscal disciplinarians, however. Nobel laureate economists Joseph Stiglitz and Paul Krugman are both passionate advocates of the view that it is way too soon to be tightening any fiscal belts.

Stiglitz has compared appeasing the financial markets with trying to reason with a crazy man. He notes that after Spain announced a grimly austere budget the credit rating agencies downgraded its debt anyway, citing lower growth prospects because of those cuts. "You can't win with markets."

Better to support the economy through higher public spending on things that will help the economy grow faster in the long term, Stiglitz argues.

Krugman sees the current recovery as a brief hiatus in what could become a long depression.

He believes both the United States and Europe are well on the way towards the kind of deflationary bog Japan found itself stuck in during the 1990s. They have unemployment rates that would have been considered catastrophic not long ago.

But instead of policymakers concluding they have not yet done enough to promote recovery there had been a stunning resurgence of the "old-time religion" of hard money and balanced budgets, Krugman wrote in the New York Times.

Whoever is right in this argument, the upshot is that New Zealand businesses have to do business in a world where fiscal austerity is the order of the day in Europe, the US has a jobless recovery and and a daunting fiscal challenge of its own and where China is tightening monetary policy in the face of a property bubble.

At home the long process of shedding debt and repairing balance sheets grinds on. Credit growth is at a standstill: the net increase in bank debt over the past year was zero.

Lending to the household sector, which makes up 60 per cent of the total, as of May was up 2.5 per cent on May last year, which in turn was up just 2.6 per cent on a year earlier.

But business lending was down nearly 10 per cent from its peak in January 2009 and at its lowest level since February 2008. And even with export commodity prices at record highs, lending to the agriculture sector was up a scant 3.3 per cent on May last year. That contrasts with average year-on-year growth of 16 per cent over the previous five years.

This needs to continue.

Relative to incomes, household debt levels have become very stretched by historical standards and as interest rates climb so will the share of income needed to service that debt. Meanwhile the torpid state of the market suggests dairy land prices have got too high as well. Much of the growth of the last decade was borrowed.

Now we face the bill.