Hair shirt or inflation? Two ways out of a deficit
The speculative blowouts around the internet in 2001 and 2002, and sub-prime and insurance monoline crises starting in October 2007 were perhaps inevitable and, given their size, lengthy corrections were necessary. Overall, the past seven or so years have had their share of pain.
The US economy was in a political cycle in 2004, as the government used fiscal spending to stimulate the economy. Rates of growth in US government spending were back to where they were 35 years ago at the height of the Vietnam War. In 2005, the tragedy of Hurricane Katrina, and the continuing demands of the wars in Afghanistan and Iraq fuelled the government spending spree. It is no accident that governments in many countries are the largest advertising spenders: ministries use marketing to reinforce their policies and build electoral popularity. Perhaps for political reasons, former President Bush failed to deal with the twin fiscal and trade deficits. He chose not to raise taxes and Federal Reserve chairman Ben Bernanke did not hike interest rates even further.
All this was thrown into sharp relief by the sub-prime, insurance monoline, private equity and house price crises that started to hit hard in the third quarter of 2007. Everyone but Goldman Sachs seemed caught unawares – and, for a short time, even the masters of the universe were. Economic policy is in sharp reverse, with massive injections of liquidity and significant lowering of interest rates being the cornerstones of the new economics, as banks continued to refuse to lend to one another and third parties.
Given the massive Keynesian fiscal stimulus of around $13 trillion and counting being pumped into the world’s economy through government spending and guarantees, there was little doubt that the post-Lehman difficulties would be overcome in the short term. After all, the US and UK have even resorted to quantitative easing or printing money, not only once, but several times. But what happens in the long term? There seem to be two possible routes. First, the hair shirt route of reducing government deficits by cutting state spending and increasing taxes, thus increasing unemployment and encouraging a higher propensity to save. All very painful stuff as we saw on a smaller scale in the 1970s and 1980s. (The three-day week and rubbish piling up in the streets is the nearest we have been to the current crisis since the Great Depression.) The UK Coalition Government has taken this route, not cutting spending, as some suggest, but reducing the rate of increase, as government spending will rise from £700 billion in 2010 to £740 billion in 2014. In inflation-adjusted terms spending falls, but you do not run a business on that basis, do you? With a fixed five-year political term to play with, the Coalition Government does have the room to deal with the deficit and build a comprehensive long-term economic plan based mainly on education, infrastructure and technology.
The other route, which is politically easier, is to inflate our way out long term. It will be difficult for government or even central banks to know when to withdraw the current support, particularly as President Obama suffered in the mid-term elections in 2010 and faces a Presidential Election in 2012. The UK’s ex-Prime Minister Brown suffered in the polls in May 2010 and Germany’s Chancellor Merkel suffered a crucial state election defeat in the same way. It would be very unpopular politically to wear the hair shirt by increasing unemployment. Much easier to inflate our way out of it, reducing the real value of debt and increasing long-term interest rates. It is doubtful, however, that the redistributive and healthcare policies of the US president will be effective to deal with the debt burden and, in any event, may have harmful effects on entrepreneurial motivation and corporate activity or eventually be rejected at the ballot box. US deficit reduction looks like it will be left until after 2012, unless there is a strike in the bond market and Pimco’s refusal to buy US Treasuries spreads. If this scenario plays out, the high-saving countries – Brazil, Russia (getting its act together again as oil prices rise), India, China and even, perhaps, Japan – will benefit and pull further away from the West.
Inflation, of course, as long as it is controlled, is not bad for our clients or us. By giving our clients pricing power, branding and innovation become even more important, as long as private label does not become too dominant. Another consequence of massive government stimulus, effectively state directed capitalism (akin to the Chinese model) is government as a client. Country branding, foreign direct investment, tourism, export stimulation, reinforcement of government policy are all examples of marketing needs at government level – witness GroupM’s win of the COI’s media buying in the UK. The British government was the country’s largest media spender but not for long, although there will be recovery.