Lately we keep hearing that there seems to be evidence that the worst of the crisis is over and that the world is already on the road to recovery. This may be the case in certain countries and regions, and may not yet be the case in others. However, on a global level there seems to be data supporting that some recovery is under way. To some extent this should not be a surprise given the extraordinary expansionary monetary and fiscal policies applied in a large majority of countries in recent months. Moreover, an interesting question could be, how would the world economy look now if those policies had not been in place? We should not forget that interest rates are close to zero in Japan and the United States, not much higher in the eurozone, and that budget deficits have soared to unprecedented levels in most developed countries. The US deficit, for example, is expected to be the largest since 1945, measured as a percentage of GDP, and most European countries will vastly exceed the 3% limit set by the Stability and Growth Pact.
The application of these policies was, to a large extent, “expected” given the need to put in place countercyclical policies during a recession. Likewise, policies that do just the opposite, i.e. increase interest rates and decrease public deficits, will be needed as the recovery takes place. However, there are a number of very difficult decisions that will have to be made in relation to the timing of the policies –namely, which policies need to be applied first, and how to balance them. And very efficient “fine tuning” will be needed.
In relation to the timing there is a risk that “pulling back” too fast too soon may push the economy back into a recession. In fact, if you have deficits climbing to 8 or 10% of GDP, resulting in fast-rising public debts, there may be a temptation to pull away from a deficit fast enough to control the public debt, instead of continuing to increase it with future deficits. However, if the role of these very large public deficits has contributed significantly to the recovery, as is reasonable to assume, then pulling out these resources too fast can be very dangerous. The same can be said about increasing interest rates too fast, because, for example, inflation fears increase. This may seem premature at the moment, with few exceptions such as Australia, but we may see more of this in future months. A fast increase in interest rates may repress consumption and investment and therefore abort recovery.
But apart from the timing of the exit policies, there are also issues related to the balance between the monetary and fiscal policies. Given the very large expansionary fiscal policies, resulting in public deficits, many already highly indebted industrialized countries are seeing their debt to GDP ratio increase fast. And there is interest to be paid on this debt. If any of these countries “pull out” of the monetary policy faster by increasing interest rates, they may increase the burden of the debt while “cooling down” economic growth. This can be dangerous because the debt to GDP ratio would continue to increase and this could lead to a vicious circle of higher public debt leading to higher interest payments on the debt, which in turn leads to higher expenditure next year, leading to a new deficit and new increases in the debt. So a very fine balance needs to be found. It will be necessary to reduce public deficits gradually as the recovery becomes more extended, avoiding a withdrawal which, if too fast, could lead back to a recession. At the same time interest rates will also probably go up gradually, in order to avoid interest on the public debt becoming too large and to ensure that growth prospects are not thwarted by the higher interest rates. It will be a very interesting time in terms of economic policy.