Herman Van Rompuy, President of the European Council, arrives with his wife Geertrui Windels at Toronto International Airport to attend the G-8 and G-20 Summits in Huntsville and Toronto, June 24, 2010.

G-20 Summit: The leaders of the world's biggest developed and emerging economies meet in Toronto this weekend and in recent weeks arguments about fiscal tightening and more stimulus measures to bolster the fragile recovery in the rich world, have moved to centre stage.

On Thursday in Washington DC, legislation to extend unemployment subsidies for hundreds of thousands of Americans who have exhausted their jobless benefits looked doomed as Senate Democrats and Republicans argued over who was to blame for an eight-week impasse on the $112bn measure. Republicans are opposed to tax increases in the bill, and Republican Senate leader, Mitch McConnell, insisted that Republicans would not support any increase in the deficit.

Last Friday, President Obama said in a letter to the other G-20 leaders:"We need to commit to fiscal adjustments that stabilize debt-to-GDP ratios at appropriate levels over the medium term. I am committed to the restoration of fiscal sustainability in the United States and believe that all G-20 countries should put in place credible and growth-friendly plans to restore sustainable public finances. But it is critical that the timing and pace of consolidation in each economy suit the needs of the global economy, the momentum of private sector demand, and national circumstances. We must be flexible in adjusting the pace of consolidation and learn from the consequential mistakes of the past when stimulus was too quickly withdrawn and resulted in renewed economic hardships and recession. For our part, we will pursue measures to support the recovery in private demand and return the unemployed to work. At the same time, we recognize the importance of setting a credible medium-term fiscal path: that is why my Administration will cut the budget deficit we inherited in half by FY 2013 and work to reduce our fiscal deficit to 3 percent of GDP by FY 2015, which will stabilize the debt-to-GDP ratio at an acceptable level in that year."

Obama  also referred to exchange rates in his letter and on Saturday, China took the issue off the Toronto agenda by announcing an end to the renminbi peg to the US dollar and a reversion to the managed float system with a link to a basket of currencies which operated in 2005-2008 and saw a 17.5% appreciation of the Chinese currency against the US dollar. 

This week, US economist Paul Krugram told Handelsblatt, the German business newspaper, that Axel Weber, the Bundesbank president, would be "a risk" for the Eurozone if he became president of the European Central Bank. He wrote in the Guardian: "Many economists, myself included, regard this turn to austerity as a huge mistake. It raises memories of 1937, when FDR's premature attempt to balance the budget helped plunge a recovering economy back into severe recession. And here in Germany a few scholars see parallels to the policies of Heinrich Brüning, the chancellor from 1930 to 1932, whose devotion to financial orthodoxy ended up sealing the doom of the Weimar Republic.

But despite these warnings, the deficit hawks are prevailing in most places – and nowhere more than in Germany, where the government has pledged €80bn in tax increases and spending cuts even though the economy continues to operate far below capacity."

Jean-Claude Trichet, ECB president, in the European parliament earlier this week. "We are in a situation where a lack of confidence is operating against recovery," he said. "A budget policy which from a certain point of view you might describe as restrictive is in fact a policy which we would call confidence building."

Wolfgang Schäuble, the German finance minister, wrote in the Financial Times on Thursday: "Behind the calls for us to pursue a more expansionary fiscal course lie two different approaches to economic policymaking on each side of the Atlantic. While US policymakers like to focus on short-term corrective measures, we take the longer view and are, therefore, more preoccupied with the implications of excessive deficits and the dangers of high inflation.

So are German consumers. This aversion to deficits and inflationary fears, which have their roots in German history in the past century, may appear peculiar to our American friends, whose economic culture is, in part, shaped by deflationary episodes. Yet these fears are among the most potent factors of consumption and saving rates in our country. Seeking to engineer more domestic demand by raising government borrowing even further would, here at least, be counterproductive. On the contrary, restoring confidence in our ability to cut the deficit is a prerequisite for balanced and sustainable growth."

Discussing the debt crisis in Europe and the future of global financial regulation, with Christine Lagarde, French Finance Minister:

The criticism of Germany is misplaced as it is maintaining an expansionary policy in 2010 and the four-year €80bn fiscal measures are not significant in the Eurozone;'s biggest economy, accounting for about 30% of economic output. However, the German move prompted France to consider reform of its costly pensions system.  According to The Economist, no French government has balanced its budget since the early 1970s. The French public debt has grown steadily higher and higher.  According to independent studies of France’s public finances, expenditure on the pensions system could drive France’s public debt up to 98.7% of GDP (gross domestic product) in 10 years’ time from 77.6% in 2009.

Within the 16-member Eurozone, fiscal austerity is focused on the Eurozone "peripheral" countries of Spain, Portugal, Ireland and Greece: which account for only around 15% of the region's GDP.

Offsetting the impact of fiscal tightening is the steep fall in the euro. On a trade-weighted basis, the currency has dipped 10% compared with a year ago.

Hedge fund billionaire George Soros, who would likely profit from the euro collapse that he has been predicting, says in the FT today: "The policies currently being imposed on the Eurozone directly contradict the lessons learnt from the Great Depression of the 1930s, and risk pushing Europe into a period of prolonged stagnation or worse. That, in turn, would generate discontent and social unrest. In a worst case scenario, the EU could be paralysed or destroyed by the rise of xenophobic and nationalist extremism."

It is easy to engage in hand-wringing from the columns of newspapers.

The US is pushing for fiscal stimulus and Germany is pushing for austerity, so there will be no coordination at the G20 summit, Marco Annunziata from Unicredit said. Germany is competitive and could do more to stimulate and grow the euro, but the weaker countries should be more competitive, Annunziata told CNBC Thursday:

We know from the Irish experience, necessary reforms would not be implemented without external pressure but Soros is wrong in assuming that the so-called PIGS are not getting significant assistance.

Ahead of this weekend's G20 meeting there seems to be a transatlantic rift developing over whether or not to introduce austerity measures. David Miller from Cheviot Asset Management has analysis:

As for serious austerity, the UK government provided it in its budget last Tuesday as it seeks to reduce a massive budget deficit of £156bn.

Real cuts of 25% in departmental spending will result in hundreds of thousands of job losses.

As to whether it will work, luck and a stronger recovery than is expected in the short-term, will be needed.

According to Martin Wolf of the FT, on average, the annual contribution of government consumption to economic growth is forecast to fall from about plus half a percentage point between 2000 and 2008 to minus half a percentage point between 2011 and 2015. Again, private consumption contributed an average of 1.7 percentage points to growth in the earlier period. This is forecast to be just 1.2 percentage points between 2011 and 2015.

The average contribution to growth of gross fixed capital formation and net exports was 0.5 percentage points and minus 0.3 percentage points, respectively, between 2000 and 2008; these figures are expected to jump, to 1.2 percentage points and 0.7 percentage points, between 2011 and 2015. The depressed level of investment, the low interest rates and the big fall in the real exchange rate make these shifts conceivable. But they are far from assured.

Investment and exports will replace borrowing and spending.

UK Prime Minister David Cameron is greeted by Minister of Transport and Infrastructure John Baird on his arrival in Canada for the G-8 and G-20 summits, Thursday, June 24 2010.

G-20

Founded in 1999 in the aftermath of the Asian financial crisis, the G-20 - Group of Twenty - began as a forum for finance ministers and central bank governors who met once a year to discuss international economic issues. It later evolved into the premier leaders forum for international economic cooperation and the first meeting of G-20 leaders was hosted by President George W. Bush in Washington, DC, on November 14-15, 2008.

Ten Commandments for Fiscal Adjustment in Advanced Economies

IMF chief economist Olivier Blanchard and Carlo Cottarelli, director of the IMF’s Fiscal Affairs Department say that advanced economies are facing the difficult challenge of implementing fiscal adjustment strategies without undermining a still fragile economic recovery. Fiscal adjustment is key to high private investment and long-term growth. It may also be key, at least in some countries, to avoiding disorderly financial market conditions, which would have a more immediate impact on growth, through effects on confidence and lending. But too much adjustment could also hamper growth, and this is not a trivial risk. How should fiscal strategies be designed to make them consistent with both short-term and long-term growth requirements?

They offer ten commandments to make this possible. Put simply, what advanced countries need is clarity of intent, an appropriate calibration of fiscal targets, and adequate structural reforms. With a little help from monetary policy, and from their (emerging market) friends.

Commandment I: You shall have a credible medium-term fiscal plan with a visible anchor (in terms of either an average pace of adjustment, or of a fiscal target to be achieved within four–five years).

There is no simple one-size-fits-all rule. Our current macroeconomic projections imply that an average improvement in the cyclically-adjusted primary balance of some 1%age point per year during the next four–five years would be consistent with gradually closing the output gap, given current expectations on private sector demand, and would stabilize the average debt ratio by the middle of this decade. Countries with higher deficits/debt should do more, others should do less. Such a pace of adjustment must be backed-up by fairly specific spending and revenue projections, and supported by structural reforms (see below). 

Commandment II: You shall not front-load your fiscal adjustment, unless financing needs require it.

For a few countries, frontloading may be needed to maintain access to markets and finance the deficit at reasonable rates—but, in general, a steady pace of adjustment is more important than front-loading, which could undermine the recovery and be reversed. Nonetheless, a non-trivial first installment is needed: promises of future action will not be enough.

Current fiscal consolidation plans in advanced G-20 countries imply on average a reduction in the cyclically adjusted deficit of some 1¼%age point of GDP in 2011, with significant dispersion around this according to country circumstances. This seems broadly adequate, and consistent with commandment I, at least based on current projections on the recovery of aggregate demand. This said, while front-loading fiscal tightening is, in general, inappropriate, front-loading the approval of policy measures (which would become effective at a later date) will enhance the credibility of the adjustment.

Commandment III: You shall target a long-term decline in the public debt-to-GDP ratio, not just its stabilization at post-crisis levels.

High public debt tends to raise interest rates, lower potential growth, and impede fiscal flexibility. Since the early 1970s, public debt in most advanced countries has been the ultimate absorber of negative shocks, going up in bad times, not coming down in good times. In the G-7 average, gross debt was 82% of GDP in 2007, a level never reached before without a major war. The current fiscal doldrums are due not only to the crisis, but also to how fiscal policy was mismanaged during the good times. This time, it must be different: the final goal must be to lower public debt ratios, gradually but steadily.

Commandment IV: You shall focus on fiscal consolidation tools that are conducive to strong potential growth.

This will require a bias towards (current) spending cuts, as spending ratios are high in advanced countries and require highly distortionary tax levels. Some cuts should be no brainers: for example, shifting from universal to targeted social transfers would involve significant savings, while protecting the poor. Containing public sector wages—which have risen faster than GDP in several advanced countries in the last decade—will be necessary.

This said, nothing should be ruled out. Countries with low revenue ratios and large adjustment needs—like the United States and Japan—will also have to act on the revenue side. Promising “no new taxes,” in all countries and circumstances, is unrealistic.

Commandment V: You shall pass early pension and health care reforms as current trends are unsustainable.

Increases in pension and health care spending represented over 80% of the increase in primary public spending to GDP ratio observed in the G-7 countries in the last decades. The net present value of future increases in health care and pension spending is more than ten times larger than the increase in public debt due to the crisis.

Any fiscal consolidation strategy must involve reforms in both these areas. This includes Europe, where official projections largely underestimate health care spending trends. Given the magnitude of the spending increases involved, early action in these areas will be much more conducive to increased credibility than fiscal front-loading. And will not risk undermining the recovery. Indeed, some measures in this area—while politically difficult—could have positive effects on both demand and supply (for example, committing to an increase in the retirement age over time).

Commandment VI: You shall be fair. To be sustainable over time, the fiscal adjustment should be equitable.

Equity has various dimensions, including maintaining an adequate social safety net and the provision of public services that allow a level playing field, regardless of conditions at birth. Fighting tax evasion is also a critical component to equity. For VAT, a tax that is relatively resilient to fraud, tax evasion averages about 15% of revenues in G-20 advanced countries. Evasion for other taxes is likely to be higher.

Commandment VII: You shall implement wide reforms to boost potential growth.

Strong growth has a staggering effect on public debt: a one%age point increase in potential growth—assuming a tax ratio of 40%—lowers the debt ratio by 10%age points within 5 years and by 30%age points within 10 years, if the resulting higher revenues are saved. An acceleration of labor, product and financial market reforms will thus be critical. 

In the current context of weak aggregate demand, reforms that increase investment are more desirable than reforms that increase saving. While both have positive long-run effects,  investment friendly reforms increase demand and output in the short run, while saving friendly reforms do the opposite. A word of caution, though: the timing and magnitude of the effects of structural reforms on growth are uncertain: fiscal adjustment plans relying on faster growth would not be credible.

Commandment VIII: You shall strengthen your fiscal institutions.

Sustaining fiscal adjustment over time requires appropriate fiscal institutions. The current ones allowed a record public debt accumulation before the crisis. They are insufficient. This requires better fiscal rules, including in Europe; better budgetary processes, including in the United States, where, at least for Congress, the budget is essentially a one-year-at-a-time exercise; and better fiscal monitoring, including through independent fiscal agencies of the type recently created in the United Kingdom.

 Commandment IX: You shall properly coordinate monetary and fiscal policy.

If fiscal policy is tightened, interest rates should not be raised as rapidly as in other phases of economic recovery. Calls for an early monetary policy tightening in advanced economies are misplaced.

Commandment X: You shall coordinate your policies with other countries.

In a number of advanced countries, the reduction in budget deficits must come with a reduction in current account deficits. Put another way, if the recovery is to be maintained, the initial adverse effects of fiscal consolidation on internal demand have to be offset by stronger external demand. But this implies that the opposite happens in the rest of the world.

In a number of emerging market economies, current account surpluses must be reduced, and these countries must shift from external to internal demand. The recent decisions taken by China are, in this respect, an important and welcome step. Policy coordination will also be important in some structural areas: for example, over the medium term, it will be critical to protect fiscal revenues from rising tax competition.

Obey these commandments, and chances are high that you will achieve fiscal consolidation and sustained growth.