Radical solutions to the world’s debt crisis

Students of economics learn how to deal with recessions in their first semester.

To cushion the economy in a downturn and speed up the recovery, you must cut interest rates and provide fiscal stimulus. It’s as simple as that – at least according to the predominant macroeconomic models.

Over the past five years of the global financial crisis (GFC), politicians around the world have eagerly followed this advice. Governments have run big deficits, encouraged central banks to flood markets with liquidity, provided relief to struggling companies, and sent out cash cheques to taxpayers.

The results of these policies are disappointing: in most countries, economic output has barely returned to its pre-crisis level. The only thing that has gone up, dramatically so, is government debt. Throughout developed economies, public debt is now much higher than before the crisis, leaving many countries struggling to refinance and some on the brink of default.

Unfortunately, it is plain for everyone to see that the economic recipes employed to fight the crisis have not worked. On the contrary, they have only made a bad economic situation worse.

Which begs the question, if traditional remedies against a recession are ineffective, what should be done to get the world economy out of its current mess?

According to former IMF Director Vito Tanzi, who will speak to The New Zealand Initiative next week, the answer is to stop treating the GFC as if it was an ordinary recession. He believes we should regard it as a systemic crisis of governments that have grown too big.

In a recent paper, Tanzi makes a simple but important point: Among developed economies, some governments are spending 35% of GDP while others are spending 55%. Despite these enormous differences in public spending, social indicators are remarkably similar. For example, no-one would claim that France with its government spending ratio of 55.8 percent had reached a superior level of development compared to neighbouring Switzerland with its 34.8 percent government spending.

Tanzi argues that returns from government spending are diminishing and that from a certain size of government, probably around 35 percent of GDP, the yields from increased public spending are virtually zero. If this is the case, the world’s public debt crisis could be solved easily: By slashing government spending above that level.

Having unsuccessfully followed textbook advice on dealing with the GFC, it is high time to explore alternative ways of dealing with the root causes of the crisis. Whether politicians have the courage to touch Tanzi’s radical solutions is a different question.

Dr Oliver Hartwich is the Executive Director of The New Zealand Initiative. Vito Tanzi will be speaking at events in Auckland (21 August) and Wellington (22 August). Tickets are limited. To register follow the links.