A tight squeeze

DURING the financial crisis, when the global economy faced its gravest threat since the 1930s, policymakers sprang into action. To stimulate the economy, central banks slashed interest rates and politicians spent lavishly. As a result, the recession, though bad, was far less severe than the Depression.

Unfortunately, however, that quick response nearly exhausted governments’ economic arsenals. Seven years later they remain depleted. Central banks’ benchmark interest rates hover above zero; government debt and deficits have ballooned. Should recession strike again, as inevitably it will, rich countries in particular will be ill-equipped to fend it off.

Just how much wriggle room do they have? For comparison, The Economist has devised a composite measure of debt, deficits and interest rates—the weapons policymakers typically wield to dispel threatening conditions. Though crude, the analysis yields a clear and troubling conclusion. A few economies could mount a robust defence against a new shock, but most are sitting ducks.

For interest rates, we assign a value of 100—meaning maximum wriggle room—to rates of 10% or higher. The Federal Reserve’s main policy rate was just above 9% (or 90, in our measure) before the recession of the early 1990s, and just over 6% (60) before the downturn of 2001. It is now down to 0.125% (a mere 1 point). At the beginning of 2007 the average central-bank policy rate in the countries in our ranking was just under 4%—low by historical standards. The average for rich countries now is 0.3%.

Though a few central banks in Europe are experimenting with negative rates, none has dared to go far into negative territory. In other words, a rate of 0% (0 points in our ranking) leaves central banks with little or no wriggle room in monetary policy. Yet they will probably remain close to that level for some time to come. Futures prices suggest that the Fed’s main rate will be around 2% in early 2018. Traders expect the Bank of England’s to be about 1.5%, and those in Europe and Japan to remain stuck near zero.

Central banks will not be alone in fighting off the next shock. Governments will try to help by increasing spending on things like unemployment benefits and infrastructure, as they did during the financial crisis. But countries cannot simply borrow as much as they would like. Ireland was spurned by private creditors when the rescue of its failing banks pushed its deficit to more than 32% of GDP in 2010, leading it to seek a bail-out from the European Union. Ireland excepted, no other rich country ran a deficit of more than 16% of GDP at any point in the crisis.

In our wriggle-room ranking, therefore, we give countries a score of 100 if they run a budget surplus of 5% or more, and 0 for deficits of 15% or greater. Most have seen a large improvement on this measure since the darkest days of the crisis, thanks both to a return to growth and to austerity. The average budget deficit this year is forecast to fall to 2% of GDP, down from nearly 6% in 2010. Before the crisis, however, the countries in our analysis, on average, boasted a small budget surplus.

The mountain of public debt accumulated since 2007 adds a further constraint. Debt as a share of GDP is, on average, 50% higher than it was before the crisis. In a new paper economists at the IMF provide fresh estimates of the “fiscal space” available to governments, taking account of their past behaviour. We assign a score of 100 to countries that, in the IMF’s view, could borrow a further 250% of GDP or more and 0 to those, including Greece, Italy and Japan, that it judges to be testing markets’ faith. Almost all countries have much less room for manoeuvre than in 2007.

Gloom, doom and room

Combining the three measures yields a worrying picture. Norway, South Korea and Australia come top: all have kept their interest rates clear of zero and have very low debt loads. On average, the rich world’s wriggle room has fallen by about a third since 2007. The leeway of hard-pressed countries such as Italy and Spain has shrunk by nearly half (see chart).

These estimates, though instructive, do not settle the question of which countries have run out of economic firepower. Take Japan, the most constrained of the countries in our ranking. The IMF thought Japan had no fiscal space in 2007, when its debt-to-GDP ratio stood at 183%, yet it has continued to borrow heavily since. Italy allegedly ran out of fiscal space during the crisis. Yet its borrowing costs, which rose to alarming levels in 2011, actually began falling in 2012, after investors became convinced that the European Central Bank would buy Italian debt if necessary. Debt limits seem not to bind when economies have a strong external financial position—or when a central bank can be counted on to buy up debt in a pinch. The ECB’s reluctance to lend its printing presses to euro-area governments may explain why debt burdens have been more burdensome within the single-currency area.

Yet even the ECB is now testing the boundaries of fiscal space. After policy rates fell close to zero early in the crisis, central banks printed money to buy bonds in an effort to provide additional stimulus—a policy known as quantitative easing (QE). The lower long-term interest rates and higher asset prices that resulted, they reckoned, would boost investment. With policy rates expected to stay low indefinitely, QE may become a measure of first resort.

Central banks’ capacity to conduct QE is theoretically limitless: they can buy as many bonds as governments issue. Such outright monetisation of debt should eventually lead to soaring inflation. Yet the experience of Japan, where the central bank now owns almost 30% of the public debt, suggests markets will tolerate much more QE than economists had thought. Wriggle room seems to expand with central banks’ readiness to print money.

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