No Pain, No Gain E-mail
MICHAEL SPENCE | OP-EDS
Friday, 23 September 2011 09:55

A sacrifice in consumption is unavoidable


The risk of a major slowdown in the US and Europe is rising. The world is looking to policymakers gathering in Washington this week to coordinate their policy responses to the threats that scenario poses to the global economy. A serious slowdown in one economic bloc would complicate the outlook for the other. Either would also produce a growth slowdown in the major emerging markets, through a shortfall in demand that policy cannot safely or sustainably redress in the short run.

Today’s reality for advanced economies is one of slow growth, high unemployment, and the risk of a downturn. Diminishing growth expectations are reflected in declining asset prices, which in turn are a drag on growth through a negative, precautionary wealth effect.

Yet at the moment high and rising public debt is a constraint on policy action. Delayed recognition that the problems for high income countries are substantially structural and predate the crisis has made things worse. Restoring growth means that rich countries must abandon their reliance on public or private sector deficits and debt to generate demand.

But it will take time for these economies to return to growth. Boosting productivity and competitiveness will require both policy action and private sector initiative.

To prevent a prolonged period of low growth and high unemployment, policymakers and the public alike must understand that there will need to be a sacrifice in consumption over both the short and medium terms. A quick return to pre-crisis levels of income, consumption and employment is not possible.

The starting point for policymakers is to set out a clear timeframe for deficit reduction that balances the need to limit the medium term accumulation of public debt with an imperative not to withdraw aggregate demand too quickly.

In this context, expenditures should be oriented towards investment in human capital, infrastructure and technology that support private sector restructuring and longer term growth.

But doing this without tax increases – even temporary ones – imposes a constraint that will hold back a recovery.

There are sensible proposals to follow this general path. In the US, the Bowles-Simpson Commission report, for example, tackled fiscal balance, growth and employment directly, and deserves more serious consideration than it has received.

The general challenge is common to many countries facing the dual challenges of restoring fiscal balance and sustainable growth.

Wage and income restraint, broadly shared across income groups, must be part of the process of restoring relative productivity levels and competitiveness. To pass muster politically, burden-sharing has to be – and must be seen to be – fair. A “recovery” tax devoted to these kinds of investments and to supporting the unemployed should be part of the package. Right now, the unemployed are bearing a disproportionate share of the burden.

Central banks continue to play key roles in ensuring financial stability and in disrupting destructive bouts of contagion and negative market dynamics. The ECB’s intervention in the Italian and Spanish sovereign debt markets in August was a good, though controversial, example. But as US Federal Reserve chairman Ben Bernanke asserted in Jackson Hole, central banks have important but limited roles. They do not reduce deficits, invest in human capital, infrastructure and technology, or carry out reforms of tax and regulatory systems and of labour markets.

They can contribute to achieving what is sometimes called escape velocity by ensuring the financial system is not a brake on growth. But escape velocity will not be achieved if the growth engines in the economy are not powerful enough, and that requires complementary actions by government and the private sector. Thus far the reliance on monetary policy, broadly defined, has been excessive.

Finally, globalization and the growth of the developing economies have had – and will have – enormous aggregate benefits, but also growing distributional effects. This should be no surprise. There are hundreds of millions of new entrants into the interconnected global economy’s labour markets, affecting the evolution of relative prices and incomes. The reality of distributional effects across countries and more importantly across subgroups within countries is economically and politically significant. It means that an increasingly important part of domestic – and to some extent international – economic policy has to be managing these distributional effects with equity as the goal.

This may sound economically right but politically naïve. Perhaps that is true. But one of the jobs of political leadership, when it really matters, domestically and in the international domain, is to understand the challenges, communicate the realities effectively, and design and “sell” solutions directly to the electorate when the political process is gridlocked. In the end a good starting point is to tell the electorate the truth.

Where are we? We are part way there. The policy agenda in the US and Europe is shifting over to a more balanced focus on both fiscal stabilization and growth.

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