Radical solutions to world debt crisis

Published in Insights, The New Zealand Initiative’s newsletter, 17 August 2012

Economics students generally learn how to deal with recessions in their first semester. To cushion the economy in a downturn and speed up the recovery, students are taught to 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, 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 cheques to taxpayers.

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

Unfortunately, the economic recipes used to fight the crisis have failed woefully, and in fact, 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 global financial crisis as an ordinary recession and instead regard it as a systemic crisis of governments that have grown too big.

In a recent paper, Tanzi made a simple but important point: Among developed economies, some governments are spending 35% of GDP while others are spending 55%. But despite these enormous differences in public spending, social indicators in both sets of nations are remarkably similar. For example, France cannot claim that it has reached a superior level of development with its government spending ratio of 55.8% compared to neighbouring Switzerland with its 34.8% government spending.

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

Having unsuccessfully followed textbook advice on dealing with the global financial crisis, 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.