More than two years have passed since the collapse of Lehman Brothers, and we’re still waiting for the true end to the financial crisis. Sure, officially, the numbers tell us that the Great Recession is over. But the recovery that we find ourselves in isn’t deserving of the name. Unemployment in the developed world remains astronomical, demand and investment weak, and the light at the end of the tunnel still appears far off in the distance. The International Monetary Fund recently reduced its 2011 projection for global growth to 4.2%. In the most advanced economies, matters are much worse, with growth forecast at only 2.2% in 2011, down from 2.7% in 2010. The rebound isn’t getting any stronger.
What can be done? That question is being asked from Tokyo to Dublin to Washington, and there’s no ready answer. Governments and central banks have already thrown just about every tool in their toolbox at the downturn. Some of those tools have been worn down to the breaking point; others don’t seem to be fixing anything. We don’t like to admit that the world’s policymakers are running out of options. There is a limit to what traditional economic policy can do to help us climb out of severe recessions. And we might be hitting that limit.
The first problem is that the most direct and effective weapon policymakers have to stimulate sagging economies – fiscal spending – has effectively been removed from the arsenal. It became apparent earlier in 2010, during the debt crisis in Europe, that further fiscal stimulus in the developed world was becoming nearly impossible. The bank bailouts and extra spending used to fight the financial crisis have taken a dire toll on the state of national finances in the industrialized world – Ireland’s budget deficit at 32% of GDP, for example. As a result, fiscal stimulus is being withdrawn even though private activity hasn’t yet been fully resurrected to fill the void.
That’s like removing penicillin from a patient who still has a bad infection. There are those who argue that the world’s policymakers are making a grave error by worrying more about their debt levels than the stalled recovery. That’s especially the case in regard to the U.S., where Treasury bond yields remain low – a sign that investors aren’t as worried about the state of America’s national finances as politicians are. George Soros recently took this position in The Financial Times:
The Obama administration’s insistence on fiscal rectitude is dictated not by financial necessity but by political considerations. The US is not in the position of Europe’s heavily indebted countries, which must pay hefty premiums over the price at which Germany can borrow. Interest rates on US government bonds have been falling and are near record lows, which means that financial markets anticipate deflation, not inflation…I believe there is a strong case for further stimulus. Admittedly, consumption cannot be sustained indefinitely by running up the national debt…But to cut government spending at a time of large-scale unemployment would be to ignore the lessons of history.
But whether or not the new wave of austerity is harmful to the recovery, I don’t see the fiscal spigot being opened anytime soon. Political leaders aren’t being left with much choice but to cut back on budgetary spending. For some countries, their creditors (sovereign bondholders) have become so nervous about their deteriorating financial condition that further spending could lead to a collapse of confidence in their solvency and a potential debt crisis (as we’ve seen with Spain, Portugal and Ireland). In the U.S., the issue of more fiscal stimulus has become so politicized that added stimulus has become nearly impossible, whatever the state of the recovery.
That leaves us with only monetary policy. Here, too, there’s not much room to maneuver. With interest rates throughout the developed world already at near-zero levels, the usual method central bankers have to stimulate growth – lowering rates — has run its course. That doesn’t mean they won’t keep trying. The Bank of Japan last week, cut its key interest rate from 0.1% to a range of 0% to 0.1%. In other words, zero. Will that make any difference? Probably not. I can’t imagine that a significant amount more lending or borrowing will go on because interest rates are, say, 0.05% versus 0.1%.
That means central bankers will be taking more unconventional steps to get the economy moving again. The more interesting part of the Bank of Japan’s new aggressive stance is its decision to go on a $60 billion buying spree of not just government bonds, but also private assets, such as corporate bonds and real-estate investment funds. The Federal Reserve may be moving in a similar direction. Charles Evans, the influential president of the Federal Reserve Bank of Chicago, told The Wall Street Journal a few days ago that he is concerned that unemployment is not falling quickly enough, and therefore he is in favor of more measures by the Fed to pump up the economy, including purchases of Treasury bills.
Will these extra measures work? Central bankers can make borrowing cheaper and flood the economy with cash, but that doesn’t mean banks, companies and consumers will take advantage. With demand anemic in the industrialized world and unemployment high, companies and consumers have little incentive to borrow, no matter how cheaply they can do so. And banks, still repairing themselves from the financial crisis and wary of the risks inherent in a protracted downturn, are probably not eager to embark on a credit binge anyway. That’s what happened in Japan, when it held interest rates at zero for nearly the entire period between 1999 and 2006, with little impact on the real economy.
Where does that leave us? Working through the mess created during the boom years. Policymakers can support growth, soften the blow of crises, and help to resuscitate broken financial sectors, but they can’t completely resolve the problems that led to the recession in the first place. The U.S. housing market will have to find its bottom before it can start moving upward again. Those unsold houses in Spain are going to have to find buyers, or just get written off as wasteful losses. Weak European economies will have to undergo the painful reforms, to their labor markets and the public sectors, which can restore them to healthy growth. Consumers in the U.S. have to shed their debt burdens before they can start spending again. The reality is that the problems built up in the boom years of the world economy created such deep problems that it will take years to work them out of the system, no matter what policymakers do. And until then, unemployment could remain a serious problem. Here’s how Olivier Blanchard, director of the IMF research department, put it recently in a press conference:
The weakness of consumption and parts of investment in most advanced economies reflects both a correction of pre-crisis excesses which have to be corrected and the scars of the crisis. So, U.S. consumers who had (over) borrowed before the crisis are now saving more and consuming less. This is good for the long run but it is a drag on demand in the short run. Housing booms have given way to housing slumps. Housing investment in many countries will remain depressed for some time to come. Weaknesses in the financial system are still constraining credit…Bottom line, this is what leads us to predict low growth for advanced countries…With such low growth, we forecast that the unemployment rate will remain very high. The numbers here again are 9.6 percent for the US in 2010 and 10 percent for the euro (area) also in 2011.
Beyond even that, policymakers, by taking more aggressive measures, can actually make disrupt the recovery they are striving to mend. One of the side effects of the type of bond-buying program introduced by the Bank of Japan is that it can weaken the yen, which Tokyo believes is necessary to sustain an export-led recovery. In other words, the Bank of Japan’s actions are another form of currency intervention. If other central bankers (i.e. the Fed) take similar steps, that can add fuel to a currency war, which we all know can potentially undermine whatever meager recovery we might be experiencing. Let’s hope policymakers don’t make matters worse in an attempt to make things better.