Posted by: Dirk | January 9, 2009

Limits to government spending – problems in the eurozone and the US

Germany failed to auction off a batch of government bonds worth €6 bn. Only €5.24 bn were placed in the market, reports the FT. The implications are potentially devastating:

A German sovereign bond auction failed on Wednesday as investors shunned one of the most liquid and safe assets in the world in a warning for governments seeking to raise record amounts of debt to stimulate slowing economies.

The fate of the first eurozone bond auction of 2009 signals trouble ahead as governments around the world hope to issue an estimated $3,000bn in debt this year, three times more than in 2008.

Now, this could put a limit on debt-financed fiscal spending worldwide. Imagine countries like Greece or Italy, which are highly indebted and reported to pay a higher interest for their bonds than Germany. This constraint might be binding. A lot of talk focused on the limit set by the Stability and Growth Pact by the EU, which limits the amount of new debt per year to 3% of GDP. But this might not be the first problem.

At the same time, international competitiveness of European Union members is drifting apart, according to the FTD. This is the result of a study by economists of the European Commission, which has not been released to the public. According to this map, a North-South schism has opened. The Northern economies of Germany and Finland are doing very well in terms of competitiveness, while central Europe does OK and Southern and Western Europe is trailing. As a result, trade imbalances exist that will be difficult to maintain.

The picture in the US does look equally bleak. China apparently has lost appetite for treasury bonds, since the money is needed at home for their own fiscal stimulus, as reported by the NY Times:

Fitch Ratings, the credit rating agency, forecasts that China’s foreign reserves will increase by $177 billion this year — a large number, but down sharply from an estimated $415 billion last year.

China’s voracious demand for American bonds has helped keep interest rates low for borrowers ranging from the federal government to home buyers. Reduced Chinese enthusiasm for buying American bonds will reduce this dampening effect.

Mr Obama’s fiscal stimulus might still be put together, since there is still a lot of people who want safe assets. And maybe all the EU countries can finance their debt-spending. But what if that is not the case? What happens, if unemployment continues to rise and the government has neither monetary nor fiscal policy at its hands?

Well, there is still a variety of very old-fashioned ways of conducting fiscal policy. One is printing money and then spending that money. Historically, this has been a solution for governments with spending constraints more than once. Another possibility would be the (partial) default on existing government debt. A third possibility is financing extra government spending by taxation.

All these options would probably scare everybody: the people, politicians and economists. Hopefully, it does not come to this. But if it happens, economists should have discussed this possibility and possible policies, so they are ready to consult governments. Just in case.


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