Against stimulus: UK and USA don't have the social capital

In the past I have argued in the context of developing countries that deficit-financed fiscal stimuli will not work if governments cannot credibly match current tax cuts or public spending increases with commitments to future tax increases or public spending cuts of equal present discounted value. Both the US and the UK may soon face this problem of not emerging, but submerging markets.

The economic context in the UK and US over the last decade is that current account deficits have reached unsustainable levels. Domestic investment (often unproductive) exceeded domestic saving, resulting in huge capital inflows. Governments forgot about budget discipline and adopted pro-cyclical policies. Feeble financial supervision encouraged credit and asset price bubbles. Corporate governance was increasingly driven by the narrow interests of managers.

Which leads us to the social context. Business ethics and moral standards in commerce and trade have been badly eroded. Corruption, from petty bribery to wholesale enslavement of the regulator or state, became commonplace. Truthfulness and trust are increasingly scarce in politics and business. Concern for one's reputation no longer checks the use of lies as a policy instrument. One effect of this erosion of social capital is that citizens and markets have stopped believing that governments will commit themselves to any course of action that involves present or future pain.

What does this mean for the response to the current crisis? In my view, fiscal measures will not work because there is now insufficient belief, given how big the stimuli are going to have to be to make a difference, that measures to repay the sums borrowed in real terms - so ensuring fiscal sustainability - will ever be taken. The only alternatives to tax or spending pain are that the government will either permanently monetise the increased public debt or that it will default on its debt obligations.

Either of these expectations would negate the stimulus. Permanent monetisation of the vast deficits anticipated in the US and the UK would be highly inflationary. It would raise long-term interest rates and lead to inflation risk premia on public and private debt instruments too. Defaulting on debt would add default risk premia to sovereign interest rates and stifle demand. It would put an end to inward investment and lead to severe currency devaluation. Unlike the US, whose dollar is still a world reserve currency, the UK is particularly exposed in this regard, because no one has any reason other than the government's credibility to hold sterling.

I believe that the risks are too high to gamble with. Instead of fiscal expansion, the US and UK authorities should turn their credibility-limited fire-power onto monetary and structural measures, because neither of these so directly puts credibility on the line. First, they should aggressively support quantitative easing (explicitly increase the money supply) and credit easing (indemnify the Fed and the Bank of England for the credit risk on the private securities they have purchased and will purchase). Secondly, they should recapitalise the banks and provide guarantees and insurance-type arrangements to support new lending and borrowing.

As regards toxic assets, I favour either temporary nationalisation of all banks or the 'good bank' model, in which a new, clean, state-owned bank takes over all new lending, investment, and borrowing, leaving what's left of the private sector to run off its back business as best it can without further taxpayer support.

What signs are there that the risks I have described are present?

Government bond yields don't currently indicate any major aversion to US Treasury debt, though US Treasury CDS rates have recently risen to unprecedented levels. As the recession deepens and as fiscal measures raise government deficits to 12% or 14% of GDP - figures normally associated with basket cases - I expect that US sovereign bond yields will begin to reflect inflation or default risk premia.

The US is helped by its ability to borrow abroad in its own currency and the closely related status of the dollar as the world's leading reserve currency. But this elastic cannot be stretched indefinitely and I expect that US Federal deficits and the growing exposure of the US sovereign to its financial system and domestic industries will cause the dollar to weaken significantly over the next couple of years or so. The UK is already closer to that position than the US, because of the minor-league reserve currency status of sterling.

When international capital moves freely, fiscal expansion strengthens the currency if the markets believe the expansion will not undermine the long-term sustainability of the government's fiscal-financial-monetary programme - in short, if the expansion is expected to feed into growth of the real economy. On the other hand, if the deficits are monetised, the currency will fall, perhaps immediately.

One final element is important. So far, the US and UK have not experienced a 'sudden stop' - the total cessation of capital inflows to both the private and public sectors that is typical of emerging market crises. There has been a partial stoppage of flows to the banking sector and in turn to the rest of the private sector, but external capital markets still function for the sovereigns and creditworthy borrowers. That should not be taken for granted. A large fiscal stimulus from a government without fiscal credibility could be the trigger for a 'sudden stop.'

So don't do it. Focus on getting credit mechanisms and the financial system going again. Keynesian fiscal policy requires a virtuous policy maker capable of making and sustaining long-term commitments. The Obama administration is new and so far untarnished. That puts it in a better position than the UK government, which has been in office since 1997. But since many of the top names in his economic team are identified with the policies that brought us disaster, even Mr Obama has little credibility capital. Use it to get credit - and public credit - flowing again.