EXIT, FOLLOWED BY A BEAR / THE ECONOMIST BUTTONWOOD COLUMN ( VERY HIGHLY RECOMMENDED READING )

Buttonwood

Exit, followed by a bear

Nov 5th 2009
From The Economist print edition

The dilemmas facing policymakers









Illustration by S. Kambayashi









WHEN the fire is raging, it is no time to worry about water damage. Central banks and governments have flooded the system with monetary and fiscal stimulus, desperate to prevent a repeat of the Depression. Now that many countries have returned to economic growth the debate has started about how to reverse some of these extraordinary measures.

A seminar held in London this week by Fathom Financial Consulting, an independent economic forecaster, asked three former members of Britain’s monetary-policy committee—Charles Goodhart, Willem Buiter and DeAnne Julius—for their views on exit strategies. The consensus seemed to be that, in Britain’s case, loose monetary policy might be appropriate but fiscal policy needed to be tightened. Professor Buiter even had a long list of policy suggestions, from freezing health-care spending through to raising the state-pension age very rapidly, that would be politically suicidal for the government to adopt, given that an election is due by June 2010.

The withdrawal of fiscal stimulus may be the favoured choice of exit route because economists are still not convinced that it works. John Maynard Keynes argued it was the only way to get an economy out of a deep recession by reviving the “animal spirits” of consumers and businesses who were unwilling to spend. But the doctrine of Ricardian equivalence states that such a stimulus will not work.

Consumers will perceive a higher government deficit as a forewarning of future tax rises, and save a portion of the resulting handouts. There will be no “multiplier effect” from government stimulus. Fathom argues that the higher the ratio of government debt to GDP, the more likely it is that a stimulus will be ineffective and that Ricardian equivalence will apply. It thinks Britain is approaching this point.

It is also possible that, at some stage, fiscal easing could become counterproductive. If the markets start to believe a country’s deficit is out of control they will force its bond yields sharply higher, in effect tightening monetary policy. That is why economists talk of the need for governments to have a credible medium-term plan to cut their deficits.

But such a suggestion itself only raises further questions. Can any future fiscal commitment by politicians be credible, since they can always use a change in circumstances (or electoral pressure) to weasel out of their pledges? And what defines the medium term? Professor Goodhart suggested markets would not allow the British government to get away with delaying fiscal tightening until 2012, which is a mere 26 months away.

That said, if governments tighten fiscal policy too early, they risk sending economies back into recession. An increase in Japan’s consumption tax in 1997 was widely blamed for sabotaging a recovery.

The future path of quantitative easing (QE) runs into similar dilemmas. This policy allows central banks to inject money into the system by purchasing assets from the private sector. Much of the money created has been used to buy government bonds. In effect, almost all the British government’s budget deficit this year has been funded by the Bank of England. Those who herald QE as a success say it has kept bond yields down and thus reduced the cost of borrowing for everyone.

But for Ricardian equivalence to work, individual consumers, who generally prefer watching TV talent contests to genning up on financial news, must not only be aware of the scale of government debt but must also decide to put off buying Nintendo Wiis because of expectations of tax rises. Surely, if Ricardian equivalence can work for the man in the street, it must apply to hyper-rational bond investors who have all the data to hand.

They know QE will not last forever. If it is abandoned before government deficits are tamed, bond yields could soar. Furthermore, central banks will presumably want to sell their bond holdings at some point, or at least not roll them over when they mature. All this debt will end up back on the market and investors should set yields accordingly.

So perhaps bond yields are being held down not by QE, but by the expectation that interest rates will be held near zero for the foreseeable future. In effect, the authorities have bribed investors to buy assets. But rates will only be held at current low levels if the economy remains weak. As Paul McCulley of Pimco, a giant bond manager, points out, the bulls who argue for a V-shaped recovery need to be careful what they wish for. The result would be a rise in interest rates that would sabotage the chief motor of this year’s rally.

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