In John Mauldin’s recent “Outside the Box” entry, Rob Parenteau addresses something I have been thinking about and commenting on in recent discussions on economic policy. Stated briefly, deficit hawks need to answer the question of what happens to GDP if government expenditures are scaled back while the private sector remains weak. Proponents of rolling back the size of the public sector (I am one) need to consider what happens to already high unemployment and weak aggregate demand if we start to drop large numbers from the public payrolls.
Let’s revisit the GDP formula:
GDP = C (private consumption) + I (gross investment) + G (government spending) + E (net exports, or exports – imports)
In the recent recession, private consumption went down, and gross investment went down more. Government spending went up (stimulus) to compensate. Pretty much the classic Keynesian formula for overcoming demand insufficiency via temporary fiscal policy adjustment. The problem (well, not THE problem, there are many) is that the government was already running high deficits. Much the same scenario prevails in the UK and Eurozone.
It’s not difficult to understand that governments can’t run such large fiscal deficits into perpetuity, and the size of the public sector eventually becomes problematic. There isn’t much debate on that point. The real question, as in investing and much else in life, is the timing of policy reversal. Let’s return to our GDP formula for a minute. If G goes down, and C and I don’t go up by an offsetting amount, then E needs to go up in order to keep GDP from shrinking (recession). It’s the simple math of the matter.
Now we return to Rob Parenteau, who writes in the context of the Eurozone’s fiscal problems. If the overly indebted private sector is deleveraging, and the government does the same, then the nation needs to move to being a net exporter, in a big way. In his words, “the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. Yet the whole world cannot run a trade surplus.” This applies equally to trade balance between Greece and Germany, as to the US and China.
He continues: “we remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe’s [the US’s] tradable products. Countries currently running large trade surpluses view these as hard won and well deserved gains. They are unlikely to give up global market shares without a fight, especially since they are running export led growth strategies.”
There we have it, folks. Europe’s predicament is quite similar to what the US faces. How is a massive net importer going to flip the switch and become a net exporter, when many other countries are attempting to do the same? We can’t all be net exporters; on a global aggregate, the numbers have to add to zero. So, here’s a scenario: deficit hawks get their way and fiscal policy is constrained, private consumption and investment do not pick up sufficiently, and net foreign trade remains negative. How do we avoid a return to recession and a serious threat of deflation (Ben Bernanke’s dreaded enemy)?
Keep those deflation hedges handy, investors. The stock market is in a mood of sunny optimism presently, but there are serious risks ahead.