Thursday, March 25, 2010

Managing the recovery in developed economies

It cannot be denied that government interventions - monetary expansion (conventional and unconventional) and fiscal stimulus spending - in the aftermath of the sub-prime crisis played a major role in both preventing economies from slipping into a deeper recession, even a depression, and speeding and easing the recovery path. However, developed economies continue to face large unemployment rates, depressed consumer demand, and weak investment environment. Household and business balance sheets remain in bad shape and require considerable restructuring.

With things "getting worse slowly" or some form of recovery on, governments and central banks have to decide on the further course of fiscal and monetary policy actions. Supporters of continuing the aggressive government interventions point to the persistently high output gap, large unemployment rates and weak aggregate demand and advocate keeping monetary policy loose and another round of fiscal stimulus. Opponents point to the growing deficits and accumulating public debt burdens, credit markets awash with liquidity (albeit without many takers) and the resultant inflationary expectations, and demand that government scale back their interventions immediately.

In an excellent article, Prof Micheal Spence provides a sense of perspective to this debate and cautions that whatever governments do, the process of healing will take time and cannot be accelerated "beyond fairly strict limits". It may also not be desirable to do so, since that would inevitably lead to more asset bubbles that artificially boost the balance sheets, with all the resultant adverse consequences. He favors "an orderly healing process in which balance sheets are restored mostly without government intervention". He writes,

"The benefits associated with deficit-financed boosts to household income are now being diminished by the propensity to save and rebuild net worth. On the business side, investment and employment follows demand once the inventory cycle has run its course. Until demand returns, business will remain in a cost-cutting mode.

The bottom line is that deficit spending is now fighting a losing battle with an economy that is deleveraging and restructuring its balance sheets, its exports, and its microeconomic composition – in short, its future growth potential. That restructuring will occur, deficit spending or no deficit spending. So policy needs to acknowledge the fact that there are limits to how fast this restructuring can be accomplished.

Attempting to exceed these speed limits not only risks damaging the fiscal balance and the dollar’s stability and resilience, but also may leave the economy and government finances highly vulnerable to future shocks that outweigh the quite modest short-term benefits of accelerated investment and employment. Demand will revive, but only slowly.

True, asset prices have recovered enough to help balance sheets, but probably not enough to help consumption. The impact on consumption will largely have to wait until balance sheets, for both households and businesses, are more fully repaired. Higher foreign demand from today’s trade-surplus countries (China, Germany, and Japan, among others) could help restore some of the missing demand. But that involves structural change in those economies as well, and thus will take time."

Apart from these immediate issues, there is a need for more fundamental structural changes in both domestic and global economies. The much-discussed global macroeconomic imbalances and rebalancing of demand will surely have to be addressed before we can be assured of any sustainable recovery. Emerging economies, especially China, will have to consume more, and by corollary, consumers in developed economies have to save more.

The financial markets in the emerging economies will have to develop greater depth and breadth so as to accomodate a much greater share of their surpluses. They could take a leaf out of the Japanese financial markets which house the major share of domestic savings, despite the ultra-low interest rates (a de-facto government guarantee on deposits made at Japan Post have attracted huge funds - about ¥300 trillion, or more than the annual GDP of France). And finally, the macro-prudential regulation of the global financial markets will have to become more counter-cyclical and strongly enforced. All these will take time and governments can do little to expedite them in the short term.

Prof Spence also argues that best use of deficits and government debt, especially in an extended balance-sheet recession, is to focus on distributional issues, particularly the unemployed, both actual and potential. Unemployment being structural rather than the result of any perverse incentives, unemployment benefits should be expanded and extended for a limited, discretionary period and should revert back to old norms after the structural barriers fall and jobless rates decline. Given the limited fiscal space available in all these economies, it may now be more appropriate to focus more on direct employment creation policies.

Despite the well documented adverse consequences of a more aggressive interest rate policy - reduce asset prices, increase debt-service burdens, and trigger additional balance-sheet distress - he cautions against continuing the present cheap credit policy on the grounds that it will produce asset bubbles, sectoral misallocations, and keep the dollar cheap. The last will incentivize emerging economies to indulge in forex management operations to retain export competitiveness and facilitate the dollar carry-trade induced capital flight to emerging economy equity markets, and thereby postpone the inevitable rebalancing of global macroeconomic imbalances.

Unlike the easier decision on fiscal policy, the monetary policy decision is much more difficult, especially from amore systemic perspective. The balance sheets of the majority of financial institutions continue to remain in the red, and they (and the market itself) have been kept afloat by access to cheap capital and the artificially depressed debt burdens due to the ultra-low interest rates. The loose monetary policy has played a life-support role in buying time for these institutions to repair their battered balance sheets (both through firm-specific restructuring and deleveraging and the spectacular recovery in equity markets). It remains a matter of considerable uncertainty as to whether the balance sheets have recovered adequately enough for the markets to take the monetary exit without too may hiccups.

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