Too heavy on brakes might put world back in recession

Jul 7 2010 by Andrew Miller, The Journal

OVER the past month or so, fiscal policy has been centre stage across the developed world, with many countries showing renewed enthusiasm for severe belt tightening.

This matters a lot, as an overly aggressive tightening could easily prevent the global economic recovery from gathering momentum in the way that it would normally do at this stage of the cycle.

Indeed, too hefty a nudge on the brakes and the world might easily end up back in recession. And that could result in a slump and/or a prolonged period of deflation for much of the developed world.

In Europe, Germany has led the charge. Chancellor Merkel talked of “setting an example to others” when announcing additional fiscal tightening of about 0.8% of GDP in 2011.

This will bring closer the time when the government’s budget will be in balance again, a constitutional requirement in Germany.

Almost as soon as the coalition announced its new spending cuts, rumours were afoot that tax hikes would come next.

Little surprise, therefore, that President Sarkozy has raised the possibility that France too will introduce a constitutional requirement to balance its books and why the likes of Italy and Spain have announced additional tightenings of the order of 1% and 1.5% of GDP respectively over the next two years.

Not to be outdone – and worried too by credit rating agencies’ threats that the failure to act would lead the United Kingdom to lose its triple-A status – the new British Chancellor, George Osborne, in June added £40bn of additional consolidation measures to take effect over the next four years. These add to the £73bn already made by his Labour predecessor, Alistair Darling. This took the UK’s overall consolidation effort up to 6.3% of GDP – with more than two percentage points of this consolidation being made in 2011 alone.

In Japan too, there have been near-seismic shifts in both the political and policy landscape of late. The new prime minister, Naoto Kan, and his new finance minister, Yoshihiko Noda, are known to be fiscal hawks. So it’s not surprising that they have already let it be known that they intend to eradicate the primary fiscal deficit (running at 7% of GDP) within a decade.

If the United States and the main emerging nations were to jump on the fiscal tightening bandwagon, our global growth forecasts would have to come down. Fortunately, however, neither President Obama nor his counterparts in the leading developing economies are showing signs of wishing to tighten.

That may be in part because of the political cycle: once the mid-term elections are out of the way, it may be felt necessary for US policymakers to get serious about the deficit. So, US fiscal tightening is a risk for 2011 – but is not, in our view, the most likely outcome.

:: Andrew Miller is regional office head of Barclays Wealth in Newcastle