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The dangers of puffing up asset bubbles
By Nouriel Roubini |
September 28, 2009, Monday
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Print Edition
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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 recession of 2008-2009 from devolving into Great Depression II.
Policy makers were able to avoid a depression because they had learned from the policy mistakes made during the Great Depression of the 1930s and Japan's near depression of the 1990s.
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 scenarios.
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 zero percent (in the case of Sweden to even below zero), and sharply increased the monetary base through unconventional quantitative and credit easing.
In the US, 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 policy makers 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 policy makers 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 1937-1939.
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.
Second, if policy makers 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 run.
Third, even if monetary easing is phased out later rather than sooner, 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.
(The author is chairman of RGE Monitor and professor at the Stern School of Business, New York University. Copyright: Project Syndicate, 2009. www.project-syndicate.org.)
Policy makers were able to avoid a depression because they had learned from the policy mistakes made during the Great Depression of the 1930s and Japan's near depression of the 1990s.
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 scenarios.
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 zero percent (in the case of Sweden to even below zero), and sharply increased the monetary base through unconventional quantitative and credit easing.
In the US, 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 policy makers 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 policy makers 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 1937-1939.
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.
Second, if policy makers 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 run.
Third, even if monetary easing is phased out later rather than sooner, 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.
(The author is chairman of RGE Monitor and professor at the Stern School of Business, New York University. Copyright: Project Syndicate, 2009. www.project-syndicate.org.)
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