So, while further fiscal stimulus seems necessary to avoid a more protracted recession, governments around the world can ill afford it: they are damned if they do and damned if they don’t. If, like Japan in the late 1990s and the US in 1937, they take the threat of large deficits seriously and raise taxes and cut spending too much too soon, their economies could fall back into recession.
But recession could also result if deficits are allowed to fester, or are increased with additional stimulus to boost jobs and growth, because bond-market vigilantes might push borrowing costs higher.
Thus, even as mounting job losses undermine consumption, housing prices, banks’ balance sheets, support for free trade and public finances, the room for further policy stimulus is becoming narrower. Indeed, not only are governments running out of fiscal bullets as debt surges, but monetary policy is having little short-run traction in economies suffering insolvency — not just liquidity — problems. Worse still, in the medium turn the monetary overhang may lead to significant inflationary risks.
Little wonder, then, that we are now witnessing a significant correction in equity, credit, and commodities markets. The irrational exuberance that drove a three-month bear-market rally in the spring is now giving way to a sober realization among investors that the global recession will not be over until year end, that the recovery will be weak and well below trend, and that the risks of a double-dip W-shaped recession are rising.
Nouriel Roubini is a professor of economics at the Stern School of Business, New York University, and chairman of RGE Monitor.
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