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Long-Term Debt Matters

February 17, 2009

Two of the world’s biggest economies have resorted to deficit spending to mitigate the global recession.

There are many ways to try to reinvigorate a wilting economy. One is to cut taxes, which can be highly effective. Both the Japanese and the German proposals contain tax breaks. But easing taxation does not tend to produce immediate results, because consumers must tally what they have saved before they can go out and spend it.

Another method is to lower interest rates and reduce restrictions on lending to make credit more available to consumers. But here a number of problems arise. For Japan, whose interest rates are already as low as 0.5 percent, cutting rates will not have a noticeable effect; the economy is saturated with liquidity, credit is already cheap and available, and domestic demand has reached a plateau.

For Germany, monetary policy is trickier. For all practical purposes, the country has no central bank. Serving that function is the relatively autonomous European Central Bank (ECB), which might have a strong Germanic disposition but does not report directly to Berlin — and does not respond well to prodding by individual governments. The ECB has cut rates in 2008 and is receiving liquidity support from the United States. But it is not free to serve merely as an instrument of Berlin’s domestic economic policies.

Key central banks have cut rates, and governments have injected enormous amounts of liquidity into their countries’ financial systems to fire up lending once again. But banks are only slowly coming out of their shells, and it will take time for the liquidity injections to course through the systems and translate to greater credit availability for consumers.
A third means of spurring growth is through government spending that targets specific industries and social groups in order to ease costs, restore confidence and energize consumptive habits. Of course, stimulus packages have to be crafted with precision to prevent the extra funds from sinking government budgets without changing consumers’ attitudes. But a well-devised stimulus plan can give a jolt to businesses and households, creating new demand and new incentives for producers to meet that demand.

This assumes, of course, that the country in question does not chronically rely on deficit spending. Germany has a neatly balanced budget, but the stimulus package will drive it into the red. Because of the credit crunch, finding a loan is not likely, so the government will have to pay for increased public spending by issuing bonds. Finding investors willing to purchase these bonds will not be impossible, however, because the German economy has sound fundamentals and a strong industrial base and export market. It is not facing implosion anytime soon. Germany might not be able to prevent its economy from=2 0shrinking, but it can possibly slow down the process.

Japan, however, presents a different case. Tokyo consistently runs a budget deficit, which is currently at -2.4 percent of gross domestic product. Unable to endure the necessary pains that would accompany dramatic economic reform, Tokyo has relied on stimulus packages repeatedly since 1993 to fend off recession. When each package wears off, recession returns. As for paying for the recent economic packages, Japan will rely on government bonds, where it has a captive market. Japanese investors play it safe by buying bonds, and the Japanese Government Pension Investment Fund, the largest pension program in the world at about $960 billion, is 50 percent devoted to government bonds

from Stratfor.com

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