Wolf on deficits

In his article, Demand shortfall casts doubt on early austerity, Martin Wolf disagrees with the current enthusiasm for cutting current public expenditure.

His argument is that in the context of a short-term contraction of private lending and a flight to safety, there is no place for money to go but into the purchase of public debt:

“On Monday, the yield on 10-year government bonds was 1.1 per cent in Japan, 2.6 per cent in Germany, 3 per cent in the US and 3.3 per cent in the UK. Based on yields on index-linked securities, real interest rates on borrowing by these governments are very low (1.2 per cent, or less, in the US, Germany and UK). Investors are saying that they view the risk of depression and deflation as greater than that of default and inflation.”

So, cutting government deficits addresses a low-probability risk (default), while exacerbating a much higher probability risk (depression).

However, Wolf is not arguing that deficits do not matter. His argument is more subtle. It is not short-run deficits that pose a threat, it is the pension obligations of governments to their ageing populations that do.

So, governments should continue spending (certainly while interest rates remain so low) in order to make up for the contraction in private sector demand, but it should “slow the long-term growth in spending on age-related programmes”, which are quite unsustainable and pose a serious threat to the solvency of public finances.