A modern fairytale of debt-lead prosperity

After every new government injection of credit and deficit spending the commentariat declares the world economy is being salvaged. Government measures – interest-rate reductions, quantitative easing and increased spending are accompanied by a new confidence in the world returning to the earlier normalcy of sustained growth. If those offering such views are disappointed by data a few months later consistently negating their optimism, they don’t show it.

Today, June 4, brought news that cast doubt on the previously foreshadowed resurrection of the US economy, with manufacturing production down. We also learned that the Nikkei plunged notwithstanding the Japanese government-fuelled credit surge. While the third horseman, the German economy saw the IMF halving its already dismal growth forecast to only 0.3 per cent for 2013. 

David Stockman, President Reagan’s head of budget, in his book The Great Deformation notes similarities with the 1920s’ credit expansion. This hoisted Wall Street and financed US exports into Europe but once the tap was turned off, as it had to be eventually, Wall Street collapsed as did US farm exports to Europe.  

Having already cut short-term interest rates to near zero, the US and Japan with quantitative easing are now targeting longer-term rates for cuts by buying such securities. But the recipients of the cash from the central bank purchases are showing no inclination to on-lend it to the investments that are supposed to ignite economic growth. Investment as a share of GDP has plummeted in virtually all OECD countries. And the very low levels of interest created by bankers’ activities would have been one factor in a corresponding decline in national savings levels across the developed world. 

In addition to stimulatory credit creation policies, there is hardly a single OECD government spending a lesser share of GDP now than in 2007. Australia’s spending is up from 34% to 37%, Japan’s from 33% to 41%, the US from 37% to 40%, and most EU countries’ governments spend in excess of 50% of GDP. Austerity is apparently defined as cutting the growth of spending. 

Most government expenditure is from taxation but much is borrowed – that is taxed from future incomes. Australia’s deficit at around three per cent of GDP is much less than the 8-10% levels of the UK, US and Japan. 

The modest growth which has been seen has come at the cost of increased debt. Last year, Australia’s 3.6% growth was accompanied by a 3.1% increase in debt as a share of GDP. Other countries paid more: France’s 0.3% growth was accompanied by a growth in its debt share of nearly 4% and the UK’s 0.2% growth saw a 5% increase in debt to GDP; the US achieved 2.2% growth at a cost of a 4% debt to GDP increase.

Not only does this demonstrate that there are sharply diminished returns in terms of growth from the increased debt but servicing this debt will present severe problems once central banks no longer depress interest rates and they return to market levels. Allowing interest rates to perform their traditional role as the price that equilibrates supply of and demand for savings must surely happen if savings are to be restored as a prelude to repairing investment and restoring growth. 

However, artificially low interest rates and deficit spending remain the order of the day in the advanced economies, almost all of which are singing from the Keynesian hymn sheet. As a result, these countries have average savings and investment as shares of 2012 GDP at around 18-19%, some 2% below their 2007 levels. They have managed GDP growth at under one per cent a year since 2006. By contrast, taken as a whole, the developing countries and former Soviet Bloc have surpassed their pre GFC levels of saving and investment and, since 2006, have seen annual GDP growth averaging 6% a year. 

Bright spots within the OECD are the low spending economies: Taiwan, Korea, Hong Kong and Singapore. These countries’ governments spend around 20% of GDP and their economies expanded by a quarter between 2006 and 2012. Those OECD economies with government spending in excess of 50% of GDP (Austria, Belgium, Denmark, Finland, France, Greece, Italy and the Netherlands) have seen their GDP expand by under one per cent during the same six year period.

The obvious message is that small government and high levels of investment and saving go hand in hand with prosperity. Sadly this seems to be lost on politicians and on most economists.

Alan Moran is the Director of the Deregulation Unit of the Institute of Public Affairs

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