Global Economy: Fiscal and Monetary Policy

For the last two years (see earlier blogs)we have emphasized that credibility of fiscal policy depends more on legal and procedural reforms that will lead to a steady and sustained reduction in the fiscal deficit over the medium-long term and less on an immediate drastic squeeze on expenditures.  Even in the few cases that the latter helps establish credibility about the former, the consequent reduction in growth will inevitably undermine the short term gains and shake the presumed “anchor.” This will inevitably require a moderation of the “excessive squeeze” and undermine any short term gains in credibility.  Thus even in the short term it is better to moderate the growth of consumption expenditures and fiscal transfers and to shift expenditures to productivity and growth enhancing investment expenditures.

In deciding on the appropriate fiscal-monetary policy mix, we have to distinguish, first between reserve currency countries,such as USA and others.  In the former case, there is a danger that a large part of the monetary expansion will transfer into rise in global commodity and asset prices, rather than enhancing domestic investment.  This is further exacerbated in the case of private consumption based on consumer credit as the failure to solve the Household mortgage problem early in the post-crises period, has resulted in  a deleveraging process that is much longer and more painful than it could have been with early action. 

In other countries, we have to again distinguish between countries constrained by currency union (e.g. EU) and those not so constrained.  In currency Union countries, self imposed constraints (EU on ECB) on monetary policy have exacerbated the crises.  Monetary policy was much tighter than it should have been. The recent loosening of monetary policy, has gone about half way to correcting the problem.  This process needs to be continued if the fear of contagion within the currency Union is to be eliminated.  The fiscal situation that matters in this case is the overall fiscal position of the currency Union, which is adequate to allow for a substantial further easing of the monetary policy approach, provided the debt of the insolvent countries is written off and all countries with tenuous fiscal situation make fundamental changes in their expenditure and tax policies to ensure future sustainability.

Will China Eclipse the USA and Dominate the World?

Virmani (2005), concluded that "the (current) unipolar world will be transformed into a bipolar world during the first quarter of this century and into a tri polar one (China, USA, India) during the second quarter of the century."  This was based on construction of a simple new Index of Power Potential (VIPP), which took account of a country's size and technological competence measured succinctly by per capita GDP, and projection of the underlying economic/demographic variables.  These projections have been updated and refined in a series of subsequent papers and books(2006, 2009).*  My latest projections for VIPP indicate that China's Power Potential (or economic power) will equal that of the USA around 2025 and exceed it by 2030, while India's will attain the US level around 2045.  Does this mean that China will 'Eclipse' the USA or Dominate the World? Not necessarily, for two reasons.
   Firstly my analysis of the Cold War period, based on the same index, shows that at the peak of its power in the 1980s the USSR had about 25% of the power potential (VIPP) of the USA. Yet the World power structure was Bipolar and considered by everyone to be so.  Second overall power depends both on economic power and Strategic power (strategic technology and assets, including arms, nuclear and aero space) which have to be factored in to get an index of overall power (VIP).  Though China will eventually catch up with the USA on this front this will happen at least a decade or two after it equals the USA's economic power.  Based on these three factors, I conclude that the World's power structure is likely to  become Bipolar, with two superpowers  (USA-China) around 2025 and to become tri-plolar, with three super powers (US, China, India) around 2035-40.
    The greater uncertainty about the latter arises from a fourth ingredient in global power. The motivation of the country (its intellectuals, government, politicians), to obtain and use global power (the 'Will to Power").  Both the USA and China have this 'will' as did the USSR, and therefore the US will eventually do all in its power to maintain its strategic lead, not least by resisting by countering China's strategy of acquiring technology by every conceivable means.  On the other hand it is not clear that India has this global motivation!  If it develops the 'will' then India will become a 'super power' by 2035, if not then it may not happen till a decade later.
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*See earlier blogs or  https://sites.google.com/site/drarvindvirmani/

Fiscal Debt Sustainability

In my 25 years of interaction with multilateral financial institutions on fiscal issues, I have repeatedly made the following points (which remain valid till today): 1) That the simple rule that growth rate must be more than the real interest rate is a good guide to ensuring that debt GDP ratio declines over time. (2) Theory does not tell us what level of the debt-GDP ratio is optimal. A number of factors are important for judging whether this level is too high. Among these are, (a) The asset owned or the net debt-GDP ratio. In other words a country with a lower debt, net of assets, can sustain a higher gross debt-GDP ratio.  Given the financial innovation over the last 25 years, it is also necessary to emphasise that the liquidity, maturity structure and uncertainty/risk associated with the assets also matters! A further implication is that debt incurred for investment is more sustainable than if used for consumption and transfers. (b) The manner of financing of the debt, in particular the proportion financed by domestic as against foreign capita/savings.  Thus countries with higher private domestic saving rates can sustain a higher level of debt to GDP and vice versa! (c) The demand conditions in the economy relative to potential supply.  An economy sufferring from lack of effective demand (virtually all advanced economies today), need to balance policy measure to ensure medium-long run debt reduction, with investment in public and quasi public goods in the short run to ensure effective demand.  If this is not done, growth will suffer and debt-GDP ratios will end up higher than they could be!  However, in economies suffering from excess demand (several Emerging economies today) and inflation, immediate fiscal (expenditure) contraction can allow a more relaxed monetary policy that will sustain growth and accelerate debt reduction.