How to deal withe financial crisis of 2008

The following article is from the Economist

Public debt 

The biggest bill in history

THE worst global economic storm since the 1930s may be beginning to clear, but another cloud already looms on the financial horizon: massive public debt. Across the rich world governments are borrowing vast amounts as the recession reduces tax revenue and spending mounts—on bail-outs, unemployment benefits and stimulus plans. New figures from economists at the IMF suggest that the public debt of the ten leading rich countries will rise from 78% of GDP in 2007 to 114% by 2014. These governments will then owe around $50,000 for every one of their citizens (see article).

Not since the second world war have so many governments borrowed so much so quickly or, collectively, been so heavily in hock. And today’s debt surge, unlike the wartime one, will not be temporary. Even after the recession ends few rich countries will be running budgets tight enough to stop their debt from rising further. Worse, today’s borrowing binge is taking place just before a slow-motion budget-bust caused by the pension and health-care costs of a greying population. By 2050 a third of the rich world’s population will be over 60. The demographic bill is likely to be ten times bigger than the fiscal cost of the financial crisis.

Will they default, inflate or manage their way out?

This alarming trajectory puts policymakers in an increasingly tricky bind. In the short term government borrowing is an essential antidote to the slump. Without bank bail-outs the financial crash would have been even more of a catastrophe. Without stimulus the global recession would be deeper and longer—and it is a prolonged downturn that does the greatest damage to public finances. But in the long run today’s fiscal laxity is unsustainable. Governments’ thirst for funds will eventually crowd out private investment and reduce economic growth. More alarming, the scale of the coming indebtedness might ultimately induce governments to default or to cut the real cost of their debt through high inflation.

Investors have been fretting on both counts. Worries about default have been focused on weaker countries in the euro area, particularly Greece, Ireland, Italy, Portugal and Spain, where the single currency removes the option of unilateral inflation (see our special report). Ireland’s debt was downgraded for a second time on June 8th. Fears of inflation have concentrated on America, where yields on ten-year Treasuries reached nearly 4% on June 10th; in December the figure was not much above 2%. Much of this rise stems from confidence about economic recovery rather than fiscal alarm. Yet eye-popping deficits and the uncharted nature of today’s monetary policy, with the Federal Reserve (like the Bank of England) printing money to buy government bonds, are prompting concerns that America’s debt might eventually be inflated away.

Justified or not, such worries will themselves wreak damage. The economic recovery could be stillborn if interest rates rise too far too fast. And today’s policy remedies could become increasingly ineffective. Printing more money to buy government debt, for instance, might send long-term bond yields higher rather than lower.

What should policymakers do? A sudden fit of fiscal austerity would be a mistake. Even when economies stop shrinking, they will stay weak. Japan’s experience in 1997, when a rise in consumption taxes pushed the economy back into recession, is a reminder that a rush to fiscal tightening is counterproductive, especially after a banking bust. Instead of slashing their deficits now, the rich world’s governments need to promise, credibly, that they will do so once their economies are stronger.

Lord, make me prudent—but not yet

But how? Politicians’ promises are not worth much by themselves. Any commitment to prudence must include clear principles on how deficits will be shrunk; new rules to stiffen politicians’ spines; and quick action on politically difficult measures that would yield future savings without denting demand much today, such as raising the retirement age.

Broadly, governments should pledge to clean up their public finances by cutting future spending rather than raising taxes. Most European countries have scant room for higher taxes. In several, the government already hoovers up well over 40% of GDP. Tax reform will be necessary—particularly in places, such as Britain and Ireland, which relied far too much on revenues from frothy financial markets and housing bubbles. Even in the United States, where tax revenues add up to less than 30% of GDP, simply raising tax rates is not the best answer. There too, spending control should take priority, though there is certainly room for efficiency-enhancing tax reforms, such as eliminating the preferential tax treatment of housing and the deductibility of employer-provided health insurance.

The next step is to boost the credibility of these principles with rules and institutions to reinforce future politicians’ resolve. Britain’s Conservative Party cleverly wants to create an independent “Office for Budgetary Responsibility” to give an impartial assessment of the government’s plans. Germany is poised to pass a constitutional amendment limiting its structural budget deficit to 0.35% of GDP from 2016. Barack Obama’s team wants to resurrect deficit-control rules (see article). Such corsets need to be carefully designed—and Germany’s may prove too rigid. But experience from Chile to Switzerland suggests that the right budgetary girdles can restrain profligacy.

Yet nothing sends a stronger signal than taking difficult decisions today. One priority is to raise the retirement age, which would boost tax revenues (as people work longer) and cut future pension costs. Many rich countries are already doing this, but they need to go further and faster. Another huge target is health care. America has the most wasteful system on the planet. Its fiscal future would be transformed if Congress passed reforms that emphasised control of costs as much as the expansion of coverage that Barack Obama rightly wants.

All this is a tall order. Politicians have failed to control the costs of ageing populations for years. Paradoxically, the financial bust, by adding so much debt, may boost the chances of a breakthrough. If not, another financial catastrophe looms.