Stimulating the Economy

The Gross Domestic Product (GPD) for a country is the total of consumption “C” (personal and business) plus Investments plus Government spending plus exports minus imports.

GDP = C + I + G + (X-M)

 

Economists from the “Keynesian school” argue that when there is a drop in C due to a recession that the G must rise to offset the drop. That is why governments around the world used stimulus packages to try and minimize the recession. There is little doubt that governmental stimulus packages did help keep a very deep recession from turning into an even deeper depression.

 

The expectation now is that the recovering economies will allow consumption to rise decreasing any need for government deficits. Some countries such as Greece have so much governmental debt that they cannot borrow favourably and have had to implement massive spending cuts. That affects public servants in particular, as the only area they can make really large savings is by reducing the wage bill. This can either be done through massive job cuts, or by pay cuts. The Greeks have chosen to go down the pay cut route, as they already have unacceptably high levels of unemployment.

 

Reducing government deficits too quickly run the risk of accentuating the effect of a recession. There has to be a balance. Greece has promised to cut its deficit by around 4% a year for 3 years. Spain is also making deep cuts. The British are also tackling this in their recent budget and mini budgets.

 

Reducing government budget deficits will also reduce GDP. That means governments collect less taxes making the deficits worse which means you have to make more cuts than planned which means lower tax receipts. Ireland is working hard to reduce its deficits but their GDP has dropped by almost 20%! If we think that this is bad, the former soviet countries Latvia and Estonia have seen their nominal GDP drop by almost 30%!

 

The Euro currency countries such as Greece and Ireland cannot print their own currency and use inflation to advantage. They are stuck with the low inflation levels of Europe. Instead the only way they can get back to competitiveness is by decreasing their production costs. A lot of this is the cost of labour, so the choice effectively becomes reduce the number of workers or reduce their hourly rate.

 

Britain, while being an EU country controls its own currency. Britain is now running about 5% inflation. Real economic growth (after inflation) could be 3% for a total of nominal growth of 8%. If Britain can get their deficit to GDP down to 6%, then they would actually be seeing the relative size of their debt being reduced.

 

From an investor’s perspective, debt is not adjusted for inflation. A country can run a deficit that is less than their nominal GDP essentially forever. For bond investors this can be disastrous. Inflation proof bonds are great in high inflation rate environments and look set to make a comeback.