What was the underlying cause of the economic and financial crisis that began in the summer of 2007? I believe that it was an explosion of private sector credit, driven by excessively easy monetary policies and declining credit standards. This led, in turn, to various “imbalances”, including inexplicably high asset prices, sharp increases in the risk exposure of financial institutions, unprecedented spending excesses in many countries (consumption and private debt in the US and investment in China), global trade imbalances, and a marked shift of factors of production into sectors like construction likely to suffer from excess capacity going forward.
These imbalances were the root cause of the economic and financial crisis that we are all too familiar with. But the crisis has not yet succeeded in reducing these imbalances to manageable levels. This implies a clear danger. Policies designed to stabilise the global economy and restore growth, while temporarily effective, could potentially make the imbalances problem worse. The global economy would then still be on an unsustainable growth path, with future crises likely. Such an outcome could and should be avoided.
In spite of the very unusual nature of the current crisis, it is indeed striking that policymakers have generally responded in traditional, if much exaggerated, ways. Monetary policy was eased dramatically, and then supplemented by credit and quantitative easing. Automatic fiscal stabilisers were allowed free rein, which meant more welfare spending despite less tax revenue. Furthermore, these measures were often supplemented by discretionary fiscal expansion. Massive government support was also provided to the financial system and to special work programmes designed to keep workers in their old jobs.
Unfortunately, each of these policies could also have undesirable medium-term effects. Very easy monetary conditions could lead either to another round of debt accumulation and asset price bubbles, or even overt inflation, with emerging market economies seeming the most vulnerable at this juncture. Moreover, they keep alive indebted “zombie” companies and “zombie” banks, which a recession should normally weed out, threatening the survival of otherwise healthy competitors.Fiscal stimulus adds to government debt and could lead to a dangerous increase in sovereign risk premiums, while the interactions between higher debt service, higher debt and still further increases in risk premiums could culminate in either default or sharply higher inflation. As for government support for the financial system, public authorities at the height of the crisis loudly asserted that a system in which some institutions seemed too big to fail was in need of fundamental reform.Yet their support has, in fact, resulted in banks that are even bigger, more complex and systemically dangerous than they were before. As for schemes to keep workers in their old jobs, this could easily impede needed adjustment from unprofitable to profitable endeavors.
Recognising that policies have mediumterm effects as well as immediate ones leads to two conclusions. First, “exit” policies need to be considered sooner than those who focus only on immediate effects might think appropriate. Second, stimulative policies should be relied upon most heavily where they are not already encumbered by dangerous imbalances of one sort or another. This implies a particularly important role for creditors in the process of global rebalancing.
On the one hand, there would seem to be little room to increase consumer spending and residential investment in countries like the US or the UK. Household debt levels are already unusually high and many consumers are already retrenching.In China, with fixed investment heavily reliant on bank credit and now almost 50% of GDP, further stimulus of this sort would seem increasingly likely to result in unprofitable endeavors, rising credit losses and even greater global trade imbalances. As for government contributions to demand, virtually all OECD economies have government debt levels that are worryingly high, with massive demographic challenges still to come. And, finally, many countries seem to want to rely on exports to stimulate demand, but their principal markets are in countries burdened with both internal and external debt problems, and, at best, moderate demand. In any event, for the global economy as a whole, exports cannot be the answer.
On the other hand, not all global spending categories are debt constrained. In many emerging market economies, consumption levels are low and household debt still minimal. Since many of these countries, in particular China, are running trade surpluses, there is no external debt constraint either. Similar observations apply with respect to some OECD economies, not least Germany and Japan. There would also seem to be room for more private sector investment, particularly in countries like the US and Germany where corporate investment levels have been low for many years, and where balance-sheet conditions are favourable. Changing demographics and concern for climate change offer new business opportunities supporting advanced technology and construction, as well as associated services. Moreover, many countries with large trade deficits need more investment to increase the production of tradable goods and services.
Governments could play a big role in encouraging investment. A “pro-business” political environment would be very helpful for private sector investment everywhere, in contrast to the “anti-business” policies that contributed materially to the severity of the Great Depression in the US. Further, were governments to allow many important prices to move to more “natural” levels, the need for the economy to adjust would stimulate many new investments. Subsidies for fossil fuels should be removed, as should subsidies to encourage manufacturing in countries with large external surpluses. Countries with large trade surpluses should also allow their exchange rates to rise, since this would encourage both more consumption at home via imports and spur more investment elsewhere.
Finally, governments could do more to encourage public sector investment. In many emerging markets, infrastructure remains inadequate, while in many advanced market economies that infrastructure has suffered terribly from neglect in recent years. Supposing that the headwinds arising from the “imbalances” are likely to be long lasting, there should be no fear that this kind of spending will come on line only when the need for stimulus is long past. And since it provides an asset to go with the associated increase in government liabilities, such spending should also be much more acceptable to financial markets.
A key question is how debts that constrain current and prospective spending might be reduced. Only two complementary possibilities suggest themselves, assuming that recourse to inflation is rejected as being both too costly and too likely to get seriously out of hand.
The first possibility is to raise potential growth by removing many of the current barriers that inhibit such growth. The OECD has focused for years on such issues, and no further analysis is needed here (see references). Nevertheless, it is worth noting that crises can present windows of political opportunity for structural changes that would normally be fiercely resisted by vested interests.
The second possibility is enhanced recourse to bankruptcy and debt workouts. While distasteful to many, it can be to the mutual advantage of creditors and debtors, and done in such a way as to minimise moral hazard and the risks of encouraging further crises. Debt alleviation frees up productive resources for other uses, and it reduces the debt–and also the uncertainty about debt servicing–that inhibits spending. Evidently, if carried far enough, confronting frankly the debt problem of borrowers requires the restructuring and possible bankruptcy (or nationalisation) of lenders as well. While challenging, such a process would seem better than the alternative of refusing to face up to reality: if the money is already gone, the only relevant question is how the losses are to be distributed. Many, including myself, would contend that this type of policy error was the real cause of stagnation in Japan through much of the 1990s and even beyond.
How can the global economy be put on a sustainable growth path? First, recognise that, in some cases, simple demand stimulus can do harm as well as good. Second, focus on those kinds of demand and those forms of stimulus that do not make existing imbalances even more unsustainable. Finally, take steps to reduce the burden of debt to more manageable levels, particularly by pursuing structural reforms to increase potential growth. Evidently, none of this will be quick or easy. But, as Groucho Marx once said about getting older, “It sure beats the alternative”
OECD (2010), Economic Policy Reforms 2010: Going for Growth, Paris.
OECD (2009), “Economy: Thoughts on the crisis”, special section in OECD Observer No 270/271, December 2008- January 2009.
©OECD Observer No 279 May 2010