As we've written before, unwinding the toxic assets on the Fed's balance sheet is basically an impossible task. The economy going forward is sapped of vitality by the very projects that kept Great Depression II from arriving. In fact, it is Great Depression II on prozac. No fundamental reform has occurred. Only the mood of the patient has been altered.
Finding the Policy Exit
September 22, 2009
NEW YORK – 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 2008-2009 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 1930’s and Japan’s near
depression of the 1990’s.
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 2008 and the spring of 2009, an L-shaped
economic and financial Armageddon was still firmly in the mix of plausible
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 United States, the euro zone, the United Kingdom, 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 0% (in
the case of Sweden to even below zero), 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 in 1998-2000, just as the US did in
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.
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 markets’
confidence would allow a looser fiscal policy to support recovery in the short
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: 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.