Posted on January 12, 2011

Fiscal Austerity Winds Blow

The shift from fiscal stimulus to restraint is a painful one, particularly given the moderate pace of recovery and the persistent weakness in some sectors of the economy. To be sure, Canada’s problems are mild in comparison to those of the peripheral European countries and the federal and state governments in the U.S., but it does raise the spectre of fiscal drag in Central and Atlantic Canada, which face much larger deficits than in Western Canada.

Ontario has the biggest challenge in the country with its fiscal deficit running at about 3% of provincial GDP and the hard-hit manufacturing hub in Ontario retarding government efforts to begin the budget balancing last year. In contrast, Quebec and Nova Scotia have already begun the process through a series of tax hikes. The U.K. is confronted with an even bigger mess because its currency is falling. Britain is dramatically tightening policy through very large tax hikes and tough spending cuts, while inflation through import prices has risen to over 3%, putting pressure on the Bank of England to reconsider its aggressively easy monetary policy. The BoE must stand firm, however, because excess capacity assures that inflationary pressures are likely to be temporary.

Moreover, the deficit-reduction effort depends critically on low financing rates, which brings us to the conundrum in Portugal. Just like in Greece and Ireland, the cost of funds for Lisbon has risen sharply in recent days. And, though Wednesday’s bond issue went reasonably well, Portugal remains under pressure to request assistance from the European Financial Stability Facility (EFSF). Next up might be Belgium, and possibly Spain—a much more serious issue because Spain’s financing needs are potentially larger than the other EFSF borrowers combined. The facility is woefully inadequate to finance Spain, let alone Italy, without a substantial increase in its borrowing authority, which to date, has been thwarted by Germany. Inevitably, the facility will be increased, creating the start of a Eurobond market. Japan has already offered to buy about €1 billion worth of these bonds at the first auction later this month. The bonds will be attractive investment vehicles for many countries wishing to diversify their foreign exchange holdings and pick up yield. Interest rates on these bonds will be higher than in Germany—well above yields available on U.S. Treasuries, and they will be rated triple-A. The creation of a Eurobond market to fund at least part of peripheral Europe’s needs is a viable and attractive option, except for France and Germany already borrowing at lower rates. It will be supported by China as well, reinforcing its long-held desire to diversify away from the U.S. dollar. The Canadian provinces, on the other hand, have no trouble financing their deficits at reasonable rates. Foreign demand for Canadian government bonds has risen significantly, reflecting the positive (albeit) small spreads between Canada and the U.S. (up to 7 years), and the continued strength in the Canadian dollar.

One overlying key issue is the future of U.S. financial hegemony as the source of the world’s only reserve currency. There is little doubt that over the longer run, the dollar will be joined by other currencies in that role. Certainly, China has taken actions to gradually support that development as it broadens the tradability of its currency and slowly diversifies its holdings in its huge sovereign wealth fund. An orderly and gradual move to a multi-reserve-currency world would be healthy, reducing the imbalances between the rich-debtor status of the U.S. and the poor-creditor status of China; but anything that would cause a dramatic loss of confidence in the greenback would be highly destabilizing and damaging for all market participants. This behoves the U.S. to progress toward longer-term deficit reduction through a series of steps to cut the structural deficit over the rest of this decade. Restructuring entitlement spending is essential and so is the elimination of many tax expenditures, such as mortgage interest tax deductibility and corporate subsidies. This does not preclude, however, cuts in U.S. corporate tax rates which, with the impending Japanese cuts, are soon to be the highest in the world. Fiscal restraint in all countries and local governments requires strong leadership and political compromise. Early indications since the U.S. mid-term elections suggest that Washington might well be up to the task, but stay tuned.