Budget deficits are on the tip of many tongues these days. We’re all feeling a little more comfortable than we were one year ago, and have turned our attention to massive government spending. What we forget is that the government spending is the gift horse that makes this feel like a recovery. According to many, most (if not all) of the growth over the past couple quarters is due to government spending.
Now we have sovereign debt crises of varying degrees popping up all over the world. Investors are pummeling European government debt, and worries over Japan and the US continue to mount. We must spend money to keep the economy going, but we increasingly don’t have the money to spend.
To be frank, we’re snookered.
Simon Johnson explains that European rising credit default probabilities could create another catastrophic domino collapse of the global financial system. Many banks and hedge funds have sold credit default swaps on European sovereign credit and will have to pay-up as default risk rises. In his own words:
Another Lehman/AIG-type situation lurks somewhere on the European continent, and again our purported G7 (or even G20) leaders are slow to see the risk. And this time, given that they already used almost all their fiscal bullets, it will be considerably more difficult for governments to respond effectively when they do wake up.
My guess is that government deficits will persist. Any attempt to reign in budgets will result in a 1937-like economic relapse back into depression. Politicians cannot live with this – this is a matter of votes, not long-term economic viability. Words from the G-7 summit:
“We need to continue to deliver the stimulus to which we are mutually committed and begin looking at exit strategies to move to a more sustainable fiscal track,” Canadian Finance Minister Jim Flaherty.
So if investors are punishing sovereign debt issues for unsustainable government budget deficits, where will the money come from? Indebted governments simply can’t afford the growing debt servicing costs that investors are starting to demand.
The answer: if governments continue to spend, which they will if final demand doesn’t take the reigns of the recovery, and if investors grow increasingly wary of sovereign credit, governments will be forced to print money to monetize their budget deficits.
Is the recession over or has the depression just begun?
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