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Olivier Blanchard on Why 2011 Turned Out So Much Worse than Expected

To the extent that people think that I am smart--to the extent that I have been smart at analyzing what has been going on over the past five years--it is because a have a functional OBEM, a functional Olivier Blanchard Emulation Module, operating in my neocortex:


2011 In Review: Four Hard Truths: What a difference a year makes…

We started 2011 in recovery mode.... The issues appeared more tractable: how to deal with excessive housing debt in the United States, how to deal with adjustment in countries at the periphery of the Euro area, how to handle volatile capital inflows to emerging economies, and how to improve financial sector regulation. It was a long agenda, but one that appeared within reach.

Yet, as the year draws to a close, the recovery in many advanced economies is at a standstill…. I draw four main lessons from what has happened.

  • First, post the 2008-09 crisis, the world economy is pregnant with multiple equilibria—self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications. Multiple equilibria are not new…. What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets—largely future tax receipts….

  • Second, incomplete or partial policy measures can make things worse….

  • Third, financial investors are schizophrenic about fiscal consolidation and growth. They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds…. I should be clear here. Substantial fiscal consolidation is needed, and debt levels must decrease. But it should be, in the words of Angela Merkel, a marathon rather than a sprint. It will take more than two decades to return to prudent levels of debt.  There is a proverb that actually applies here too: “slow and steady wins the race.”

  • Fourth, perception molds reality…. [N]ot much happened to change the economic situation in the Euro zone in the second half of the year. But once markets and commentators started to mention the possible breakup of Euro, the perception remained and it also will not easily go away.  Many financial investors are busy constructing strategies in case it happens….

Is all hope lost? No, but putting the recovery back on track will be harder than it was a year ago. It will take credible but realistic fiscal consolidation plans. It will take liquidity provision to avoid multiple equilibria. It will take plans that are not only announced, but implemented. And it will take much more effective collaboration among all involved. I am hopeful it will happen. The alternative is just too unattractive.