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This is a year of fiscal folly

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October 03, 2005 12:54 IST

This is truly turning out to be the year of fiscal recklessness. President Bush has committed himself to spending billions of dollars rebuilding the Gulf Coast in the wake of Hurricane Katrina and not raising revenues.

This confirms the fact that the Bush administration is clearly the most profligate administration in US history. Since 2001, the Federal government's spending has gone up by roughly 33 per cent, taking the Federal budget deficit close to 4.5 per cent of gross domestic product. $1.4 trillion of tax cuts are due over the next decade and despite the emergence of unforeseen costs like hurricane Quatrain, the administration shows no sign of rolling back some of the tax rebates on offer.

Germany, Europe's largest economy, is today the sick man of Europe -- its GDP growth languishes below 1 per cent. One out of every three German workers is unemployed. The country desperately needs a hard-headed fiscal reformer who takes on the massive inefficiencies of the overburdened social security and pension systems and revamps labour laws.

Yet the elections for the Federal government failed to produce a decisive mandate. Germany now faces the prospect of being ruled by a coalition government with parties of every ideological hue.

Perhaps even a fresh round of elections that most analysts predict will fail to produce anything more decisive. Readers in India should hardly find it surprising that a coalition government is unlikely to throw up a radical overhaul of the system.

The fiscal problems of the two key growth centres of the world, China and India, are fairly well-known and are certainly not getting better. The only difference between the two is that while China chooses to hide its excesses in the balance sheets of its state-owned banks, India is a little more transparent.

The bottom line is that both the economies have public sectors (I use the phrase in the broader sense of the government and its affiliated agencies) that are deep in debt and their governments don't seem to be particularly keen on doing something about it.

The point in copiously listing these things that are somewhat well-known is to reassert the fact that things aren't half as perfect as global asset markets would have us believe.

In fact, things have come to such a pass precisely because the onus has shifted to asset markets to restore macroeconomic equilibrium. These markets have, however, displayed singular disdain for these structural problems that they were expected to "price in" and focused on the short term.

Let me give you a couple of examples of the disconnection between asset prices and macroeconomic fundamentals. There is, for one, no reason why despite the obvious costs of reconstruction in the Southern US coast and the US Federal government's growing deficit, the US 10-year bond continues to trade at a yield of less than 4.5 per cent and not 5.5 or 6 per cent, where it should realistically be.

The US runs a current account deficit of over 6 per cent of GDP-- I see no earthly reason why the US dollar has continued to appreciate against the yen and euro this year.

This disconnection has been compounded by the fact that some of the most powerful central banks have played along with the asset markets, infusing massive doses of liquidity when rectitude was in order.

The Fed might have raised rates ten times over the past year or so, but the fact remains that these hikes were long overdue. The current level of the policy (Fed Funds) rate is still about a percentage point below what could be construed as a sensible "neutral rate" compatible with the growth rate.

The Chinese central bank's steps to hike interest rates and revalue the yuan have at best been cosmetic and have had no effect either on growth or the trade surplus.

What is likely to happen as a result of these large and growing imbalances? Macroeconomic theory suggests that in the short to medium term, interest rates will rise. In the longer term, deficit-strapped governments will be forced to raise taxes. Both have a negative impact on growth.

If key input prices like oil continue to remain high despite weaker growth, we might end up with a phase where slower growth comes with higher inflation levels or "stagflation".

Like a "deux ex machine" in a Greek tragedy, natural catastrophes seem to be taking the lead in restoring a semblance of fiscal equilibrium. Katrina, for one, has made everyone aware that large budget deficits on the back of non-priority spending have the potential of "crowding out" priority spending such as those of rehabilitation and rebuilding.

It is quite likely that as rebuilding activity in the US commences, US interest rates will move up sharply and slow down growth. Over the medium term, a withdrawal of some of the tax breaks seems inevitable.

As the US economy slows down as a result, it will have huge knock-on effects on economies like China that have, essentially, fed off the US economy's reckless expansion.

There is a more immediate risk that is likely to surface and in the very short run, and that is Alan Greenspan's departure from the Fed at the end of January next year. One could question his style and his objectives as central banker but few can question his credibility among market participants.

With a less charismatic (and perhaps more conservative) chairman at the helm, asset markets could just begin to fall in line with macroeconomic truths. Next year can then well be the beginning of the end of a period of global expansion.

The author is chief economist, ABN Amro. The views here are personal.
Abheek Barua in New Delhi