Obstfeld on Fiscal Space

Today’s beach reading has been Maurice Obstfeld’s keynote talk to a Bank of Japan conference last month.  Here’s the precis in his own words:

My  main point today will be that a precautionary approach to fiscal policy, leading to moderate  levels of public debt in relation to GDP, is essential for the credibility of government promises to  support the financial system, as well as the broader economy. Clearly defined rules that limit  fiscal exposure must also inform the endgame of winding down insolvent financial institutions.

The slightly longer version of his argument runs like this: finance has become ever bigger in relation to the size of national economies, and more concentrated too.  Regulation can’t keep up with innovation, and future crises are predictable.  Central banks can do only so much before they run the risk of igniting inflation, so it falls on treasuries to provide the ultimate backstop.  But full-bore treasury support can push up against the limits of fiscal space.  Knowing all this in advance, governments are advised to run smaller fiscal deficits than they would otherwise in order to maintain an extra fiscal space buffer.

In other words, in order to enjoy the magical economic gains made possible by financial hypertrophy, we need to forego some of the fiscal flexibility we enjoyed in the past.  Less investment in education and infrastructure, I guess, to be ready to bail out finance when it chokes again.  It’s a bizarre form of hostage syndrome.

The road not taken in 2008 was not backstopping the financial system, but replacing it with a smaller, publicly managed substitute.  That road is still there, although it is now overgrown with weeds and harder to get at.  We should remind ourselves of this from time to time, when demands are made on other aspects of economic policy—countercyclical policy, labor markets, social insurance—to accommodate the needs of finance in its current form.