However, in the aftermath of the events of the past eighteen months, both these holy cows are now under attack and are being increasingly blamed for the current recession and the failure of governments to adequately respond to it. It is now clear that the success of central banks and governments with achievement of these two objectives may ironically enough have exacerbated the crisis. Let us examine the respective roles of both these parameters of macroeconomic policy making.
The entrenched, almost pathological, opposition to assuming debts and running deficits have had three consequences
1. Debt averse governments dragged their feet in coming to the rescue of ailing economies, thereby possibly deepening the downturn. In keeping with the prevailing ideological beliefs, governments relied on monetary policy interventions to provide the expansionary stimulus.
2. Even when they did finally come over, the response was, except possibly China, inadequate and mis-directed. Once governments finally came round to initiating stimulus spending, the politics of formulating fiscal stimulus measures took over. Acrimonious debates erupted about the relative superiority of direct spending measures against tax cuts, and the respective multipliers of each approach. In keeping with the prevailing orthodoxy, tax cuts found more favor among the political establishments.
3. And now, at the slightest indication of deficits rising and public debt increasing, and when economies are showing nascent signs of recovery, pressure is mounting on governments to exit the stimulus and re-balance budgets.
In other words, it may be a case of too little, too late and too short! The virtues of counter-cyclical macroeconomic policy have never been more missed and knee-jerk and reactive policy making appears to have taken over.
The current recession draws attention to the necessity of a counter-cyclical fiscal policy with its thrust on running up surpluses during the upturns. Further, in view of the inevitable controversy and long-drawn out debate that accompanies any fiscal stimulus, it is important to have an appropriate level of self-acting fiscal stabilizers to cushion the economy from any steep declines in aggregate demand as policy makers debate on enacting stimulus measures. Finally, given the difficulty associated with timing an exit from expansionary policies, it is always better to err on the side of caution and exit only after there are credible enough signs that recovery has firmly taken root.
The second leg of the global macroeconomic consensus was the obsessive pursuit of low inflation. This became embodied in the almost messianical zeal with which central banks focused on inflation targeting and communicating very low inflation targets. Interestingly, this inflation focus was confined only to goods and services in the real economy and completely overlooked the asset bubbles that were building up in the financial markets. In any case, that is another matter.
However, the credit crisis that unfolded after the sub-prime mortgage bubble burst has clearly exposed the limitations of an inflation-straitjacketed monetary policy. It left central banks with limited maneuverability to expand credit flows once the credit markets froze and market confidence plunged. The related ultra-low interest rates only compounded the problem by driving economies into zero-bound interest rate induced liquidity traps and unleashed deflationary expectations. The low inflation and nominal interest rates meant that real interest rates were already too low for governments to lower it by much. In simple terms, monetary policy had lost traction.
Paul Krugman points to Olivier Blanchard's telling comment that captures the paradox of low inflation rate,
"Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions... Maybe policymakers should therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks."
Krugman also points to the work of George Akerlof, WIlliam Dickens and George Perry who claim that unlike the conventional natural rate of unemployment models (where unemployment is invariant to the rate of inflation),
"When inflation is low it is not especially salient, and wage and price setting will respond less than proportionally to expected inflation. At sufficiently high rates of inflation, by contrast, anticipating inflation becomes important and wage and price setting responds fully to expected inflation."
This effectively means that at very low inflation, getting relative wages right (by lowering them and thereby reducing unemployment) would require that a significant number of workers take wage cuts, whereas at higher inflation rates when it is very salient, it is much easier to achieve the required adjustments in relative wages.
The trouble with an approach that seeks to target a higher inflation rate is that it runs the risk of unleashing the hitherto capped inflationary expectations and thereby eroding the tenuous credibility of central banks painstakingly built up over many decades. However, as the Great Recession and Japan’s deflationary lost decade of nineties shows, the cost associated with pursuing ultra-low inflationary policies can be far higher than the risk inherent in a higher inflation target. In any case, central banks today have enough credibility and monetary and credit policy instruments at their disposal to both anchor inflationary pressures and rein in inflation if it threatens to go out of control.
When faced with a deep recession - especially one where businesses have postponed their investment and individuals their consumption decisions, and banks have shut their credit taps off – exacerbated by a zero-bound interest rate and low inflation, the only credible enough source of stimulating aggregate demand is the Government. Everything else, including deficits must take a back seat or else the economy faces the strong possibility of getting trapped in a deep trough with high unemployment, from which recovery can be long and tortuous.
Going forward, it is not going to easy for governments to suddenly reverse their macroeconomic policy stances without a complementary accommodation by the markets. In other words, it is can only be hoped that the markets will not start panicking when the "green shoots" of inflation appears, as it will with recovery taking hold, and force governments into premature tightening as is happening now with increasing deficits.