Economic policymakers should sit tight until 2011

A year has passed since the bankruptcy of Lehman Brothers and the even more catastrophic public policy failure exactly a week later, when Henry Paulson, President Bush’s Treasury Secretary, peremptorily demanded a $700 billion bank bailout from Congress. It was Mr Paulson’s testimony before the Senate on September 23, to explain what he would do with this money, that turned the crisis into a previously unimaginable nightmare, by revealing that the man supposedly in charge of the world’s most important economy literally did not know what he was talking about.

Anatole Kaletsky: Economic view

Astonishingly, we can now see with hindsight that this nightmare phase of the crisis actually lasted only three weeks. The weekend of October 10-12 was when Gordon Brown, to his enormous credit, took control of the situation from the crumbling Bush Administration. That weekend he led other European governments in offering to recapitalise the banks and effectively guaranteeing all bank liabilities with the full faith and credit of their nations.

This was the turning point in the crisis. Once governments had accepted the necessary responsibility for averting financial disaster, it was only a matter of time before their finance officials and central bankers devised the detailed programmes required to stabilise credit and revive economic growth. Now that this economic recovery is generally agreed to have started, what should we expect from the first post-crisis meeting of G20 leaders, to be held in Pittsburgh next weekend?

The immediate answer is fairly simple: nothing much is going to change in the next year or so on the policy front. The two most important issues — the outlook for interest rates and fiscal policy — were effectively settled by the G20 finance ministers and central bank governors, who met in London two weeks ago. Barring a sudden upsurge in economic activity and job creation that nobody is expecting in the next 12 months, interest rates all over the world will remain at or near zero and there will be no significant withdrawal of fiscal stimulus until the end of next year. What happens in 2011 and beyond will depend partly on the strength of next year’s economic recovery, but mainly on political conditions.

From a purely economic standpoint, the main governments and central banks, including the ECB and the Germans, would prefer to avoid any fiscal or monetary tightening until the world economy has enjoyed several years of steady growth and restored most of the output and employment lost in the post-Lehman panic. Even assuming a fairly strong “V-shaped” recovery, which I expect but most policymakers and market economists consider highly unlikely, that would take at least two or three years.

But populist pressure is, ironically, forcing governments to behave much more “prudently” and “responsibly” than they ought to on purely economic grounds. Voters’ aversion to debt and deficits is creating irresistible political pressure to tighten fiscal policy even if such tightening is economically premature or unwise. This is especially true in the United States and Britain.

In America, the Obama Administration’s hopes of legislating a second fiscal stimulus plan next year have been completely thwarted by opinion polls, which show that the budget deficit overtaking unemployment as the most important political issue on the minds of voters. The best that President Obama can hope for is to avoid an immediate fiscal tightening as a condition for passing his healthcare reform. In Britain, Mr Brown’s loss of fiscal control when he took over as Prime Minister two years ago has created an unprecedented consensus for public spending retrenchment that is necessary in the long-run but would be unwise to implement until 2011. In Germany and Japan, too, newly elected governments seem determined to rein in public spending and even in China this year’s enormous fiscal stimulus will probably be partly reversed towards the end of 2010.

The upshot is that fiscal policy in many countries will probably be tightened faster than might be desirable from a strictly economic standpoint. But the good news almost certainly implied by such over-zealous fiscal tightening is that central banks will keep interest rates much lower for longer than many businesses and investors now expect. Indeed, central bankers everywhere have been unusually vocal in suggesting that easy monetary policy would be used to offset the deflationary effects of any fiscal tightening that the US, British and European governments may undertake in the next few years.

Before Lehman, the idea that Japanese-style zero interest rates would become a global phenomenon seemed far fetched, and even nine months ago, when the US Fed, Bank of England and European Central Bank did move to zero rates, these were viewed as a strictly temporary emergency measure.

It now looks, however, as if near-zero rates will be a fixture of global economic conditions for years to come. That, incidentally, suggests that homeowners and finance directors are making a costly mistake when they pay 5 per cent plus to “lock-in” fixed-rate loans, since short-term borrowing will probably be available at less than half that price for years ahead.

Assuming that the central banks do keep interest rates ultra-low until the middle years of the next decade, the widely-feared “double-dip” or “W-shaped” recession is very unlikely to materialise, even if governments raise taxes and cut public spending aggressively in 2011 and beyond. There are, however, some very different risks implied by the combination of fiscal tightening and loose monetary policies now in prospect.

The low interest rate policy adopted by Alan Greenspan to support the US economy after 9/11 and the dot-com crash is now being implemented by the world as a whole. The probable result is that asset prices will again rise rapidly and financial activity will accelerate, even as wages and consumer inflation remain very subdued.

The challenge for policymakers in the years ahead will not be, as is now universally demanded, to prevent new asset bubbles from being created, whether in property or China or alternative energy or oil or nano-technology or whatever else may be the next investment fad. Booms and busts in asset prices are a natural feature of the capitalist system and the only way to prevent them would be either to paralyse the creativity of private enterprise or to keep the economy permanently depressed, with unemployment needlessly high.

The real challenge for policymakers, therefore, is to find ways of channelling the next upsurge of financial activity into more constructive and sustainable investments than the last one. It is a cliché to say that this will have to be achieved with better, more intrusive financial regulation — which does not necessarily mean more regulation and certainly doesn’t mean more thousand page rule-books — and perhaps also by closer collaboration between the public and private sector in technology, environmental policies and macroeconomic management. But how exactly to design these improved regulations and better public-private partnerships is far from obvious.

There is, however, one point that all the governments at this week’s G20 are likely to agree on. To suppress economic activity with rising interest rates in the name of “financial stability” would be the economic equivalent of Tacitus’ famous warning to the Romans: “They made a desert and called it peace.”  (Anatole Kaletsky, The Times)

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