There is an ongoing debate among global policymakers about when and how fast to exit from the strong monetary and fiscal stimulus that prevented the Great Recession of 2008-2009 from turning into a new Great Depression. Germany and the European Central Bank are pushing aggressively for early fiscal austerity; the United States is worried about the risks of excessively early fiscal consolidation.
In fact, policymakers are damned if they do and damned if they don’t. If they take away the monetary and fiscal stimulus too soon – when private demand remains shaky – there is a risk of falling back into recession and deflation. While fiscal austerity may be necessary in countries with large deficits and debt, raising taxes and cutting government spending may make the recession and deflation worse.
On the other hand, if policymakers maintain the stimulus for too long, runaway fiscal deficits may lead to a sovereign debt crisis (markets are already punishing fiscally undisciplined countries with larger sovereign spreads). Or, if these deficits are monetized, high inflation may force up long-term interest rates and again choke off economic recovery.
The problem is compounded by the fact that, for the last decade, the US and other deficit countries – including the United Kingdom, Spain, Greece, Portugal, Ireland, Iceland, Dubai, and Australia – have been consumers of first and last resort, spending more than their income and running current-account deficits. Meanwhile, emerging Asian economies – particularly China – together with Japan, Germany, and a few other countries have been the producers of first and last resort, spending less than their income and running current-account surpluses.
Overspending countries are now retrenching, owing to the need to reduce their private and public spending, to import less, and to reduce their external deficits and deleverage. But if the deficit countries spend less while the surplus countries don’t compensate by savings less and spending more – especially on private and public consumption – then excess productive capacity will meet a lack of aggregate demand, leading to another slump in global economic growth.
So what should policymakers do? First, in countries where early fiscal austerity is necessary to prevent a fiscal crisis, monetary policy should be much easier – via lower policy rates and more quantitative easing – to compensate for the recessionary and deflationary effects of fiscal tightening. In general, near-zero policy rates should be maintained in most advanced economies to support the economic recovery.
Second, countries where bond-market vigilantes have not yet awakened – the US, the UK, and Japan – should maintain their fiscal stimulus while designing credible fiscal consolidation plans to be implemented later over the medium term.
Third, over-saving countries like China and emerging Asia, Germany, and Japan should implement policies that reduce their savings and current-account surpluses. Specifically, China and emerging Asia should implement reforms that reduce the need for precautionary savings and let their currencies appreciate; Germany should maintain its fiscal stimulus and extend it into 2011, rather than starting its ill-conceived fiscal austerity now; and Japan should pursue measures to reduce its current-account surplus and stimulate real incomes and consumption.
Fourth, countries with current-account surpluses should let their undervalued currencies appreciate, while the ECB should follow an easier monetary policy that accommodates a gradual further weakening of the euro to restore competiveness and growth in the eurozone.
Fifth, in countries where private-sector deleveraging is very rapid via a fall in private consumption and private investment, the fiscal stimulus should be maintained and extended, as long as financial markets do not perceive those deficits as unsustainable.
Sixth, while regulatory reform that increases the liquidity and capital ratios for financial institutions is necessary, those higher ratios should be phased in gradually to prevent a further worsening of the credit crunch.
Seventh, in countries where private and public debt levels are unsustainable – household debt in countries where the housing boom has gone bust and debts of governments, like Greece’s, that suffer from insolvency rather than just illiquidity – liabilities should be restructured and reduced to prevent a severe debt deflation and contraction of spending.
Finally, the International Monetary Fund, the European Union, and other multilateral institutions should provide generous lender-of-last-resort support in order to prevent a severe deflationary recession in countries that need private and public deleveraging.
In general, deleveraging by households, governments, and financial institutions should be gradual – and supported by currency weakening – if we are to avoid a double-dip recession and a worsening of deflation. Countries that can still afford fiscal stimulus and need to reduce their savings and increase spending should contribute to the global current-account adjustment – via currency adjustments and expenditure increases – in order to prevent a global shortage of aggregate demand.
Failure to implement such coordinated policy measures – to sustain global aggregate demand at a time when deflationary trends are still severe in advanced economies – could lead to a very dangerous and damaging double-dip recession in advanced economies. Such an outcome would cause another bout of severe systemic risk in global financial markets, trigger a series of contagious sovereign defaults, and severely damage the growth prospects of emerging-market economies that have so far experienced a more robust recovery than advanced countries.