Deficit reduction and rebalanced growth are key

History reveals that financial crises and the recessions they trigger have disastrous effects on government finances. The credit crisis that exploded in the U.S. in late 2008 is no exception.

An unprecedented amount of fiscal stimulus, along with an aggressive and innovative dose of monetary easing, has restored stability to financial markets and stopped the decline into another Great Depression.

In the rescue and recovery process, however, the U.S. government’s deficit has soared to more than 11 percent of the gross domestic product, the highest level since World War II.

In spite of these disturbing trends, it would be premature to begin slashing the deficit now.

Households are tightening their belts and increasing their saving to reduce their indebtedness and rebuild their wealth. The recovery is likely to leave the unemployment rate at 7 percent or more for several years, holding down consumer incomes, confidence and spending. For most U.S. households, prudence is likely to trump profligacy for some time.

Credit is likely to remain tight, as banks continue to de-leverage and restore their balances sheets. Restrictive credit conditions, reinforced by tougher regulation, will be a significant headwind against a strong recovery in private spending. A large inventory of unsold residential and commercial property will stymie strong growth in construction, traditionally an engine of economic recovery.

Under these conditions, a robust self-sustaining recovery is far from a sure thing, and cutting the deficit by curbing spending or boosting taxes too soon might tip the economy back into recession.

Policymakers face an enormous and complicated challenge. They must lower future deficits and sustain economic growth with healthy job creation.

To address this challenge they must do two things. First, lawmakers should continue to provide significant fiscal support as long as the economy is operating far below its potential and private spending is constrained. Additional fiscal stimulus to encourage job creation in 2010 is advisable.

While these circumstances persist, there is little danger that large deficits will crowd out private spending or trigger higher interest rates or an increase in inflation expectations. Currently, a higher private savings rate in the U.S. is providing the saving needed to cover the increase in the federal deficit. As a result, despite large government borrowing requirements, long-term interest rates remain at historic lows and inflation fears are subdued.

Second, policymakers should develop a credible plan for fiscal tightening now to be implemented automatically once private demand recovers and the economy is operating close to its potential.

Passage of such a plan would prevent increases in long-term interest rates triggered by investor concerns about projected future deficits even after the economy has recovered. In addition, such a plan would reduce the likelihood of another financial crisis, caused this time by a loss of confidence in the creditworthiness of the U.S. government and a flight from the dollar.

A healthy recovery of the U.S. economy along with a gradual reduction in the deficit depends not only on policy choices made at home but also on choices made abroad. Private spending in the U.S. will be weak for several years, so when the government reins in fiscal support, growth is likely to slow unless foreign spending on U.S. goods and services fills the gap.

Weaker demand at home must be offset by stronger net exports. Between 2002 and 2008 debt-financed spending by U.S. households, encouraged by low-cost capital from the rest of the world, fueled the export-driven growth of China and much of Asia.

This pattern of global growth is no longer feasible. With a debt-ridden U.S. economy, China and other surplus nations must rely more on their own domestic demand and less on exports to the U.S. for their growth. Global growth must be rebalanced. Production must grow faster than domestic spending in the U.S., and domestic spending must grow faster than production in China and other nations with large trade and current account surpluses.

There are some promising signs that the necessary rebalancing adjustments are getting under way.

To offset the sharp dip in exports caused by the global recession, China has pumped domestic spending with a massive fiscal stimulus and an explosion of bank lending. Bank-funded investment has accounted for almost all of China’s dramatic recovery during the second half of 2009. Much of this investment has apparently been targeted not at export capacity but at infrastructure to support urbanization and rural development.

This kind of investment should boost consumption by Chinese households in the future. With the same goal in mind, Chinese authorities have also embarked on ambitious plans for investment in education, health care and social security for its elderly population.

According to Goldman Sachs Group Inc. economists, strong domestic demand growth in China is likely to be the main driver of global exports, including U.S. exports, in 2009 and 2010.

Despite these significant near-term improvements, a permanent shift in China’s growth strategy will take several years and will require controversial policies including an appreciation of the yuan which is no higher today in real terms than it was in 1998.

A return to a gradual managed adjustment of the yuan against a basket of currencies would be a compelling signal of China’s commitment to a new pro-consumption growth model. This model will benefit both China and its trading partners, including the U.S. China will enjoy better balanced and more sustainable growth, and protectionist pressures against China’s exports will ease. The U.S. will enjoy stronger net exports, and this will reduce both the risk of a double-dip recession and the need for additional fiscal stimulus. And the world will enjoy improved prospects for a healthy and sustained global recovery.

Laura Tyson, a professor of global management at the Haas School of Business at the University of California, Berkeley, is a former chairman of the President’s Council of Economic Advisors.