Saturday, 24 September 2011

A genuine exit strategy from this 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.


Anonymous said...

There is a story that Reagan and Gorbachev were discussing the power of their weapons.

Reagan said "I have these missiles which can waste a city in seconds"

Gorbachev pointed to 3 other people in the room and said "I have these 3 economists that can cause more devastation than your missiles"

Electro-Kevin said...

And they did, Anon.

Alice - Parochially. Don't forget the raison detre' of this blog is house prices.

Thus far QE has been effective at keeping nominal house prices up.

That was the quid pro quo of high-tax high-spend. 'Feel good' through the housing bubble with everything else forgiven or ignored.

One extremely vexed and brassic generation is emerging. I hear that even over 55s are feeling the squeeze.

The only way out is austerity for all but those rich enough to avoid it.

Anonymous said...

Curious to hear what you think of pension funds.

chefdave said...

While I agree with what you say, I don't want to hear the government talk about cuts, austerity and sharing the burden so we can get through this together when there's nothing in it for me.

This isn't my mess to clear up, so I won't be too amused if they intend on reducing my living standards to pay off their debt.

The Greeks have got the right idea.

Mad Numismatist said...

The problem with Keynesian stimulus is the flipside to it. For it to work, governments need some discipline during the boom, in order to have something to use during the bust. Because most governments were themselves profligate during the boom, there was no room for them to pick up the consumption and by trying they have dug an even deeper hole.

Holistically, pensions are what this is all about. We work, save and invest in order to enjoy the golden years. Everything is pointing in the opposite direction. Bond yields/ interest rates are half of what is needed, stock market returns are half of what was modelled, house prices have collapsed, and even if you have managed to net a return on pensions, the thieving banks have taken half to cover their fee’s and bonuses. And to top it all off demographics point to no chance of a change; in 2020 the UK will have around 20% LESS teenagers than we have today.

Luckily we built all those schools under the PFI, we now have a modern education sector to accept all the immigrants we need to boost the population.