Deja Vu on That 1937 Feeling
In the winter of 2009 Christina Romer tried to lay down a marker: no withdrawal of economic stimulus until the recovery was well-established: no "1937s". I had thought she had gained general asset. Apparently not.
Martin Wolf watches the train wreck:
The risks of premature tightening: Mervyn King, the governor of the Bank of England, is among the world’s most influential central bankers and leading policy economists. I greatly admire both his intellect and his integrity. Mr King has also played a big part in persuading the UK’s coalition government of the urgency of what he calls “a clear and credible plan for reducing the deficit”. To his great credit, he has just said this to the Trades Union Congress, the most unfriendly audience he could find. He went on to say: “I would be shirking my responsibilities if I did not explain to you the risks of failing to do so.” Indeed, he should say what he thinks. But is he right to think as he does? I have doubts.
That will come as little surprise to those who read my endorsement of points made by Ed Balls.... I am more fiscally hawkish than Mr Balls, as I said at that time. But I am not as hawkish as Mr King. Yes, I agree that there are risks to cutting the fiscal deficit too slowly. However there are also risks in cutting it too fast. Similarly, while there are risks in not having a credible plan, there are also huge risks in having an inflexible one....
What is the core of Mr King’s argument? It is that:
market reaction to rising sovereign debt can turn quickly from benign to malign.... It is not sensible to risk a damaging rise in long-term interest rates that would make investment and the cost of mortgages more expensive. The current plan is to reduce the deficit steadily over five years – a more gradual fiscal tightening than in some other countries. As a result of a failure to put such a plan in place sooner, some euro-area countries have found – to their cost – a much more rapid adjustment being forced upon them....
I have argued before that the UK is in a very different position from, say, Greece: it has a far lower ratio of debt to gross domestic product; it borrows in its own currency; it has the means to promote its own recovery, which is vital for managing public debt; it has a modest current account deficit; it has a history of managing its public debt well; and current indebtedness is lower, relative to GDP, than the average of the past three centuries. Markets have also been remarkably relaxed about funding these deficits: interest rates on index-linked gilts have been 1 per cent, or less, for more than a year; the yield on 10-year gilts has remained below pre-crisis levels and is now close to 3 per cent; and spreads over German bunds have been 1 percentage point, or less, throughout the crisis....
None of this would matter if the risks went only one way – from a failure to tighten rapidly. This is not so. The danger on the other side is that the economy weakens sharply under a structural retrenchment averaging 1.6 per cent of GDP a year over five years. This would be bad for output and jobs. It would also offset the structural fiscal tightening with cyclical loosening: the UK would have to run to stand still....
As Andrew Smithers of London-based Smithers & Co has noted, one possible – even likely – offset to rapid fiscal tightening would be a collapse in corporate savings or, in other words, profits. In the context of a sharp fiscal tightening, with interest rates at rock bottom, that seems a far more plausible outcome than a surge in corporate investment as a way of achieving the needed reduction in the corporate financial surplus, which was 6.1 per cent of GDP in the first quarter of 2010. Why would that be a good thing?
It would be far more sensible to make plans for fiscal retrenchment that are explicitly contingent on how the economy recovers.... Such a flexible plan would ultimately be more credible, not less: it is quite hard to convince markets one is prepared to commit political suicide. The Chinese say one should “cross the river while feeling the stones”. When we know as little as we do, that sounds excellent advice.
