By Martin Wolf
Published: September 8 2009 21:03
“Our unprecedented, decisive and concerted policy action has helped to arrest the decline and boost global demand.” Thus did the finance ministers and central bank governors of the Group of 20 leading high-income and emerging economies pat themselves on the back over the weekend. They were right. The response to the crisis was both essential and successful. But it is still too early to declare victory.
Ben Bernanke, recently nominated by Barack Obama to a second term as chairman of the Federal Reserve, made the point at this year’s Jackson Hole monetary symposium: “Without these speedy and forceful actions, last October’s panic would likely have continued to intensify, more major financial firms would have failed and the entire global financial system would have been at serious risk. What we know about the effects of financial crises suggests that the resulting global downturn could have been extraordinarily deep and protracted.”
Two groups of thinkers reject this viewpoint. One argues that the economy is always in equilibrium. If unemployment has exploded upwards it can only be because, after Lehman imploded, workers chose to take a holiday. An alternative view is that depressions are the natural consequence of excess. Both the guilty and the innocent must suffer, as past errors are purged.
Rightly, policymakers rejected such views. Economies are not always in equilibrium and, while a correction of excesses in asset prices, financial markets and consumption had become inescapable, a cumulative downward spiral was neither inevitable nor tolerable.
The rescue of the financial system, unprecedented monetary easing and fiscal expansion (most of the latter being automatic rather than discretionary) have indeed put a floor under the world economy. JPMorgan analysts add to this a second, more temporary, element: a “correction by firms that planned for far worse economic and financial conditions at the start of the year than have been realised”. As a result, it now forecasts annualised growth of gross domestic product of 4 per cent in the US and 3 per cent in the eurozone in the third quarter.
Perhaps the most striking success has been the recovery of the financial sector. Indeed, this resurgence, while welcome, is embarrassing: financiers are back to their high-earning ways, while tens of millions of people have lost their jobs, economies are far below potential and public sector debt is exploding upwards. It is little wonder that bonus-bashing is on the menu.
Indicators of risk aversion in financial markets have improved markedly. As confidence has returned, stock markets have rebounded, though they remain well below past peaks. In the real economy, manufacturing output has stabilised: a substantial rebound is likely, as the inventory cycle turns. The consensus of forecasts for 2010 is now showing successive monthly improvement, with China and India leading the way globally and the US, as usual, leading among the big high-income countries. (See charts.)
So what should be done now? The G20 finance ministers were right to agree “the need for a transparent and credible process for withdrawing our extraordinary fiscal, monetary and financial sector support as recovery becomes firmly secured”. But having a credible plan is a very different matter from implementing it. Indeed, having a credible plan is the way to avoid premature reversal of policies.
Many worry about inflation. Currently, this borders on hysteria. More importantly, that danger will not be reduced by early withdrawal of stimulus. On the contrary, that could make the danger even bigger, since it could well provoke yet another round of aggressive interventions.
Why, then, is there no good reason to worry about inflation right now?
First and foremost, the world economy has massive excess capacity. This is impossible to measure precisely, particularly after recent upheavals. In its most recent Economic Outlook, the Organisation for Economic Co-operation and Development estimated the difference between actual and potential output this year at more than 5 per cent of potential output in its member countries. Growth next year needs to be at least 2 to 3 per cent for this gap to fall. On the latest consensus of forecasts, that will not happen.
Second, even heavy public sector debts are sustainable. The real interest rate paid by the US government on its debt, for example, is below 2 per cent. So servicing a ratio of net public debt to GDP as high as 100 per cent would cost 2 per cent of GDP. It is ludicrous to argue that this would be an insupportable burden. Moreover, for an economy growing at 4 per cent a year in nominal terms (surely the minimum one would expect of the US, in the long term), net public debt could be stabilised at 100 per cent of GDP with a fiscal deficit of 4 per cent of GDP. This is not a recommendation, but an observation.
Finally, the expansion of the Federal Reserve’s balance sheet, including the jump in the reserves of the commercial banks, will only generate inflation once lending and spending start to take off. But these are precisely the circumstances in which it will be easiest for the Fed to drain excess liquidity. True, it might wait too long. But it does not have to do so.
Now suppose that, instead of keeping calm, the authorities are frightened into premature monetary and fiscal tightening. Given the extreme fragility of the private sector, that could cause another economic downturn. The inevitable result would be another round of emergency fiscal and monetary measures. The point is fundamental: exceptional monetary and fiscal measures are not the root cause of the danger. The weakness of the private economy is at its root. The policy measures are a consequence.
All this makes the implementation of national and global “exit strategies” a matter of exquisite judgment. Almost certainly, errors will be made. But it is perfectly clear what the core elements will have to be: credibly independent central banks; a credible commitment to fiscal responsibility, in the long term; and rebalancing of global demand, away from dependence on the high-spending countries of old.
Is this going to be easy? Definitely not. Is it even going to happen? I fear not. But policymakers have at least given us the opportunity to discuss the exit. That is a success. Now we need to build a vigorous global recovery upon it.
Copyright The Financial Times Limited 2009
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