Friday, September 23, 2011

A genuine exit strategy from the crisis

In 2010, the global economy enjoyed steady if unremarkable growth. By the third quarter of 2011, it teetered on the edge of recession. The post-crisis recovery lasted barely 2 years. Moreover, in many advanced economies, growth proved insufficient to ensure that GDP reached its pre-crisis level.

How did things get so bad so quickly? The answer lies in the public sector balance sheets of advanced economies.

When banking sector difficulties turned into an economic downturn, tax revenues took a hit, while expenditures on unemployment benefits rose. In some countries, the revenue decline was exacerbated by a long-standing dependence on asset prices and financial bubbles as sources of taxes.

Politicians believed that they could buy their way out of recession. With revenues already weakening due to the economic downturn, governments tried to stimulate activity by cutting taxes and increasing expenditures, pushing fiscal deficits up to levels not seen since the Second World War. With rising deficits came rising debt levels, which were already extremely high in many socialist leaning European countries.

Few were willing to acknowledge that, at best, the post-crisis fiscal stimulus was a dangerous gamble. Supporters of stimulus claimed that higher deficits would re-energize growth, tax revenues would increase, and economies could out run the rise in debt. Skeptics, on the other hand, warned that if growth did not resume, debt to GDP ratios would start to rise alarmingly and bond markets could turn nasty.

Two years on, the skeptic's scenario is playing out. Many European economies are growing far too slowly, and debt levels are unsustainably high. Markets doubt the ability of many European countries to tackle their fiscal problems. Equity markets have crashed around the world, wiping out mountains of household wealth. Financial flows have ebbed away. Banks are now far more risk averse, and have begun to tighten liquidity and accumulate cash.

In the past, central banks would have used monetary policy to counteract these adverse circumstances. Central banks lost that option when interest rates were slashed to zero during the last downturn. Monetary policy has no room for maneuver.

In the UK and the US, quantitative easing temporarily stabilized asset prices, but the gushing pipeline of cash could not ignite economic growth on a sustainable basis. Printing cash did nothing to calm the nerves of investors, workers, or entrepreneurs. It looked like a short sighted and dubious measure, driven by panic and fear. Ultimately, QE served to destabilize economies.

A renewed recession now seems unavoidable. There are no quick fixes available to policymakers. So what should governments do?

First, and most importantly, they must begin to take the long view; no more panicked measures; no more ill-conceived headline grabbing policies.

Second, fiscal sustainability is the defining long-term issue facing advanced economies. More bluntly, the problem is debt. Governments must begin to move towards lower deficits and lower debt levels.

Third, governments must recognize that reducing debts and deficits will incur significant short-term output costs. This reality must be soberly and honestly communicated to voters. There is no time for absurd anti-cuts campaigns. It is just as pointless to protest against austerity as it is to rage against the freezing weather in winter.

Finally, no more stimulus. Attempts to kick start the economy using deficits is doomed to failure. Fiscal stimulus spawns rapidly rising debt levels and creates a serious risk of a disorderly fiscal adjustment. If you want to see the future of the country trying to stimulate its way out of recession, just take a look at Greece.

The hope has to be that we have learnt something over the last four years. There are no shortcuts to prosperity. Governments must always balance their books. Central banks should not misbehave and recklessly cut interest rates to zero and inject the economy with obscene amounts of cash. What we need is monetary and fiscal responsibility and an end to cheap policy tricks.

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