There is a general consensus that the massive monetary easing, fiscal stimulus and support of the financial system undertaken by governments and central banks around the world prevented the deep recession of last year and this year from devolving into Great Depression II. Policymakers were able to avoid a depression because they had learned from the policy mistakes made during the Great Depression of the 1930s and Japan’s near-depression of the 1990s.
As a result, policy debates have shifted to arguments about what the recovery will look like: V-shaped (rapid return to potential growth), U-shaped (slow and anemic growth) or even W-shaped (a double-dip). During the global economic free fall between the fall of last year and the spring of this year, an L-shaped economic and financial Armageddon was still firmly in the mix of plausible scenarios.
The crucial policy issue ahead, however, is how to time and sequence the exit strategy from this massive monetary and fiscal easing. Clearly, the current fiscal path being pursued in most advanced economies — the reliance of the US, the euro zone, the UK, Japan and others on very large budget deficits and rapid accumulation of public debt — is unsustainable.
These large fiscal deficits have been partly monetized by central banks, which in many countries have pushed their interest rates down to zero percent (or even below zero, in the case of Sweden) and sharply increased the monetary base through unconventional quantitative and credit easing. In the US, for example, the monetary base more than doubled in a year.
If not reversed, this combination of very loose fiscal and monetary policy will at some point lead to a fiscal crisis and runaway inflation, together with another dangerous asset and credit bubble. So the key emerging issue for policymakers is to decide when to mop up the excess liquidity and normalize policy rates — and when to raise taxes and cut government spending (and in which combination).
The biggest policy risk is that the exit strategy from monetary and fiscal easing is somehow botched, because policymakers are damned if they do and damned if they don’t. If they have built up large, monetized fiscal deficits, they should raise taxes, reduce spending and mop up excess liquidity sooner rather than later.
The problem is that most economies are now barely bottoming out, so reversing the fiscal and monetary stimulus too soon — before private demand has recovered more robustly — could tip these economies back into deflation and recession. Japan made that mistake from 1998 to 2000, just as the US did between 1937 and 1939.
But if governments maintain large budget deficits and continue to monetize them as they have been doing, at some point — after the current deflationary forces become more subdued — bond markets will revolt. When that happens, inflationary expectations will mount, long-term government bond yields will rise, mortgage rates and private market rates will increase and one would end up with stagflation (inflation and recession).
So how should we square the policy circle?
First, different countries have different capacities to sustain public debt, depending on their initial deficit levels, existing debt burden, payment history and policy credibility. Smaller economies — like some in Europe — that have large deficits, growing public debt and banks that are too big to fail and too big to be saved may need fiscal adjustment sooner to avoid failed auctions, rating downgrades and the risk of a public-finance crisis.