Second, if policymakers credibly commit — soon — to raise taxes and reduce public spending (especially entitlement spending), say, in 2011 and beyond when the economic recovery is more resilient, the gain in market confidence would allow a looser fiscal policy to support recovery in the short run.
Third, monetary policy authorities should specify the criteria that they will use to decide when to reverse quantitative easing, and when and how fast to normalize policy rates. Even if monetary easing is phased out later rather than sooner — when the economic recovery is more robust — markets and investors need clarity in advance on the parameters that will determine the timing and speed of the exit. Avoiding another asset and credit bubble from arising by including the price of assets like housing in the determination of monetary policy is also important.
Getting the exit strategy right is crucial because serious policy mistakes would significantly heighten the threat of a double-dip recession. Moreover, the risk of such a policy mistake is high, because the political economy of countries like the US may lead officials to postpone tough choices about unsustainable fiscal deficits.
In particular, the temptation for governments to use inflation to reduce the real value of public and private debts may become overwhelming. In countries where asking a legislature for tax increases and spending cuts is politically difficult, monetization of deficits and eventual inflation may become the path of least resistance.
Nouriel Roubini is chairman of RGE Monitor and a professor at New York University’s Stern School of Business.
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