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Dealing with budget deficits Who pays the bill?

Throughout the rich world battle lines are being drawn in the coming fight over deficit reduction

WHEN friends go out to dinner, the convivial atmosphere can be shattered once the waiter brings the bill. A pleasant evening can descend into a dispute about who had a starter and who ordered the lobster. Running a public-sector deficit is similar: the arguments start when the tab has to be paid.

The battles will be all the more fierce this time around because the deficits are so large and likely in the short term to stay that way. With developed economies still weak, many governments are (often rightly) keen to run large deficits for a while longer. But the bond markets are getting impatient, especially with weaker European countries. Greece was forced to announce a third austerity package this week, after its initial efforts failed to reassure either the markets or its neighbours (see article). Although Britain has a lower debt-to-GDP ratio than Greece and its debt has an average maturity of 14 years, sterling also wobbled this week, with investors spooked by the prospect of a hung parliament. True, the three biggest rich-world economies, the United States, Germany and Japan, are under less pressure. But Japan has high debt levels and America has the government-bankrupting cost of ageing baby-boomers.

If the world were run by economists, deficit reduction would be a very complicated balancing act. For politicians one question may well dominate all others: who is going to pay? The candidates differ from country to country, but the list usually includes taxpayers, public-sector workers, entitlement recipients (such as state pensioners or public-health users), foreign investors and future generations. Already battle lines are being drawn: witness the strikes by Greece’s public-sector unions and the tea parties thrown by America’s tax protesters.

Two immediate answers appear, which should be easier for politicians to embrace than all those spending cuts and tax rises. The first is to be honest about the size of the problem. Public-sector accounting is Enronesque. Creditors will punish governments with dodgy numbers, as the Greeks have discovered. And voters can hardly make judgments about what to scale back if they do not know what promises have been made. Talk in continental Europe of an “Anglo-Saxon” conspiracy of greedy speculators is also dishonest. The speculators did not invent the deficits. As one bank analyst has tartly remarked: “You can’t blame the mirror for your ugly face.”

The second is to focus on economic growth. Higher growth reassures markets, increases tax revenues and reduces spending on unemployment benefits and other welfare payments. So politicians should eschew policies that reduce the long-term growth rate, such as protectionism or higher taxes, and focus instead on measures that boost the growth potential, such as more flexible labour markets and other productivity-enhancing reforms. No matter what taxes it raises, Japan will not solve its fiscal woes without faster growth. Many European governments are walking into the same trap.

Even assuming that most governments tell the truth a bit more and their economies grow a bit faster, there will still be hard choices. The main fault-line is often intergenerational. Some promises, particularly on public-sector pensions and health care, may impose too great a burden on the next generation. Middle-aged Americans have written cheques on the accounts of their children. Scaling back those promises, for example by raising the pension age, is a prerequisite for getting public finances in order just about everywhere, even if it will not do much to reduce the deficit in the short term.

The more immediate fight, which is already starting to break out in many European countries, is between taxpayers and public-sector workers, and between raising taxes and cutting public spending. Politically, the contest is evenly matched, pitting powerful unions against the biggest taxpayers—corporations and high-earners—who often have the ear of politicians. In terms of economics, though, the bulk of the adjustment should come in the form of spending cuts.

There is no alternative

The state had to step in during the credit crunch, given the scale of the banking crisis, but this expansion of its scope should be temporary. This is not just ideological bias on our part; economic studies suggest that fiscal adjustments that rely on spending cuts do better than those based on tax rises. Yes, some tax rises may be necessary, if only out of the political necessity of persuading the electorate that the burden is being shared. But tax rises, like Japan’s in 1997, can kill a recovery.

In the past some governments have dealt with debts by walking away from them. Iceland is voting on a milder form of that solution this weekend (see article). The graver threat this time is that countries are tempted to diminish their debts through higher inflation. But that would be a dangerous option to adopt and may not even be possible, given that markets can see such policies coming and demand higher bond yields.

Whichever path governments choose will be hard. As a period of loose credit gives way to an era of austerity, the social cohesion of many nations will be put to the test. Not all countries will pass. Over the next few years the careers of many politicians will be made and broken in the bond market. 4550