Talk about “exit strategies” will be high on the agenda when the heads of the G20 countries gather in Pittsburgh a few days from now. They will promise to reverse the explosive monetary and fiscal expansion of the past two years, to do it neither too soon nor too late, and to do it in a coordinated way.
These are the right things to promise, but what will such promises mean?
Consider first the goal of reversing the monetary expansion, which is necessary to avoid a surge of inflation when aggregate demand begins to pick up, but it is also important not to do it too soon, which might stifle today’s nascent and very fragile recovery.
Promises by heads of government mean little, given that central banks are explicitly independent of government control in every important country. US Federal Reserve Chairman Ben Bernanke, Bank of England Governor Mervyn King and European Central Bank President Jean-Claude Trichet will each decide when and how to reverse their expansionary monetary policies. Bernanke doesn’t take orders from the US president and King doesn’t take orders from the British prime minister, while it’s not even clear who would claim to tell Trichet what to do.
So the political promises in Pittsburgh about monetary policy are really just statements of governments’ confidence that their countries’ respective monetary authorities will act in appropriate ways.
That will be particularly challenging for Bernanke. Although the Federal Reserve is technically independent and not accountable to the US president, it is a creation of the US Congress and accountable to it. Because of the lagged effects of monetary policy and the need to manage expectations, early tightening by the Fed would be appropriate, but the unemployment rate could be more than 9 percent — and possibly even more than 10 percent — when it begins to act. If so, can we really expect Congress not to object?
In fact, Congress might tell the Fed that it should wait until there are clear signs of inflation and a much lower unemployment rate. Because Congress determines the Fed’s regulatory powers and approves the appointments of its seven governors, Bernanke will have to listen to it carefully — heightening the risk of delayed tightening and rising inflation.
Reversing the upsurge in fiscal deficits is also critical to the global economy’s health. While the fiscal stimulus packages enacted in the past two years have been helpful in achieving the current rise in economic activity, the path of future deficits can do substantial damage to long-run growth.
In the US, the Congressional Budget Office has estimated that US President Barack Obama’s proposed policies would cause the federal government’s fiscal deficit to exceed 5 percent of GDP in 2019, even after a decade of continuous economic growth, and the deficits run up during the intervening decade would cause the national debt to double, rising to more than 80 percent of GDP.
Such large fiscal deficits would mean that the government must borrow funds that would otherwise be available for private businesses to finance investment in productivity-enhancing plant and equipment. Without that investment, economic growth will be slower and the standard of living lower than it would otherwise be. Moreover, the deficits would mean higher interest rates and continued international imbalances.
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