Across the industrialized world, governments have responded to the economic crisis by running enormous fiscal deficits, rediscovering a deep, previously unacknowledged love for the legacy of John Maynard Keynes. Now there seems to be a gathering consensus that these deficits are unsustainable and have to be cut as quickly as possible. This seems to be the word from the Group of 30, the OECD, the EU, Obama’s deficit commission and the US Congress.
Genuine Keynesians have to be worried. If so many governments simultaneously decide to withdraw stimulus, the combined effect could well be to tip the world into a second round of economic tailspin. Just for starters, assume a multiplier of one; then the average reduction in fiscal deficits as a percentage of combined GDP has to be deducted from projected growth rates. Given plausible numbers on both sides, the result could well be negative. A multiplier greater than one, particularly in light of trade spillover effects, pushes us further into the red.
But the economic myopia is, if anything, even more fundamental. The deficit hawks seem to have forgotten, if they ever learned, the granddaddy of all accounting identities: a country’s current account is equal to the sum of its domestic budget positions. If you hold the CA constant, a reduced fiscal deficit is feasible only if it is offset by a corresponding increase in the indebtedness of households and firms. Of course, it was the inability of the private sector to sustain its borrowing that led to the crisis, and the runup in fiscal red ink, in the first place.
Notice that the biggest pressure to cut government spending is being felt in the countries running current account deficits, like the US, the UK and the peripheral members of the eurozone. This is not surprising, since, according to the laws of arithmetic, they must also have the biggest domestic budget deficits. If squeezing the public sector could produce expenditure-switching, so that countries on a fiscal diet would also find their way to external balance without economic collapse, that would be the proper medicine. Unfortunately, there is no evident channel by which this can happen. The US and the UK are unlikely to see a substantial devaluation as a result of their fiscal rectitude, and the folks in the eurozone can’t devalue at all. If there is to be rebalancing as a result of these cuts, it will happen only through shrinkage of incomes and employment.
So that’s what the arithmetic tells us: fiscal cuts must equal the sum of increased private indebtedness plus decreased external deficits, where the latter are driven by economic contraction. Lovers of historical irony will note that this is exactly the circumstance Keynes was responding to in the 1930s, informed by his prior analysis of the imbalance-generating Treaty of Versailles. His insistence on the need for symmetry in adjustment was directed against the foolhardy insistence that deficit countries must shrink and shrink, dragging down the surplus countries as well.