The world economy
The perils of incrementalism
Nov 27th 2008
From The Economist print edition
Bold, unorthodox remedies are needed to jolt the world economy back to life
THE prognosis is looking ever more grave. What began 15 months ago with a seizure of the credit markets has become a disease with an alarming list of real economic symptoms. America, Britain, the euro zone and Japan are already in a recession that threatens to be the worst, in some places, for a quarter of a century and possibly since the Depression. American consumers, unable to borrow and fearful for their jobs, are cutting spending; so are firms, short of cash and worried about sales. German business confidence is at a 15-year low. Japan’s exports to both rich countries and emerging ones are falling. Emerging economies are suffering too, as commodity prices fall and capital flees faster than in those countries’ own crises of a decade ago. In some countries-notably the United States-a vicious deflationary spiral of banks withdrawing credit and demand contracting is no longer unimaginable.
Seeing the threat to the world economy’s vital functions, the policymakers have been working overtime. Interest rates have been cut dramatically. American rates are already down to 1%; Britain’s are at a 50-year low; and this week China’s central bank lopped 108 basis points off its main policy rate. Hundreds of billions have been pumped into banks and financial markets. Many financial institutions have been bailed out: the rescue of the once mighty Citigroup is merely the latest unthinkable to happen.
Despite all this, the patient has not responded. This is partly because some traditional remedies, such as looser monetary policy, are weakened in a credit crunch. It is also because the doctors have been ham-fisted: look at Hank Paulson’s changes of mind about whether to use America’s $700 billion rescue fund to recapitalise banks or to buy toxic assets. In addition, though, a lot of policy has been far too timid. Halting the world economy’s decline will demand something rather bolder than anything seen so far in this crisis.
Sense and the Citi
That means redoubling existing efforts in each of the three traditional areas of policy: bolstering banks; providing greater fiscal stimulus; and cutting interest rates. It also involves using more unorthodox tools, such as interfering directly in credit markets by buying up assets-a route where America’s Federal Reserve has shown the most creativity. Indeed, such “quantitative easing” is an augury for the option to be tried in extremis: reflating the economy by printing money to finance budget deficits. That risks inflation, which is economic poison; but, in highly indebted countries, it is less murderous than deflation.
Mercifully, the world is not at that stage yet. But it is getting closer. One person who seems to understand the need for action on a bigger scale is Barack Obama. In his various press conferences this week America’s president-elect laid out the nature of the challenge better than many leaders already in office. This was a “global crisis”, he argued, which merited a “global response”. The economy was “trapped in a vicious cycle” and needed a big “jolt” to ease the flow of credit and to cushion the drop in private demand. He is right.
The starting-point for many policymakers remains lowering interest rates. Central banks in some rich economies, in particular Britain and the euro zone, still have room to cut rates-though it is notable how even fairly dramatic cuts are not working as they once did. The Bank of England reduced rates by one and a half percentage points in one go this month. But with banks reluctant to lend, lower rates from central banks will not work miracles.
That suggests there is a lot to be gained in most places by concentrating more on the banks. The fact that Citigroup, the world’s biggest bank not so long ago, needed a rushed weekend rescue was an indictment of the authorities’ failures thus far, especially in America. Above all, Citi’s collapse showed the dangers of leaving huge quantities of toxic assets to fester on banks’ balance-sheets. Pumping in capital-as governments have been doing-is essential, but may not be enough. The history of successfully handled banking crises, such as Sweden’s in the early 1990s, suggest that governments also need to remove bad assets from banks’ balance sheets.
It would be good to report that the Citi deal provided a new model. Not really. The rescue is opaque-yet another ad hoc bail-out rather than part of a systematic plan; and it is too kind to the bank’s management, board and shareholders. Granted, the rescue ring-fences and limits Citi’s losses on a pile of the worst loans. But it would probably have been better to hive off its most toxic assets into a separate “bad bank”.
The charm of unorthodoxy
Looking ahead, governments in rich countries will need to do more to help their banks on both fronts-injecting capital and buying up assets. That would mean admitting to the scale of the problem: America may need more than the $350 billion left in the Treasury’s financial-rescue fund.
A more stable banking system will eventually get the money flowing, but in the meantime there are other ways. Intervening directly in credit markets makes a lot of sense in America, which relies more than other countries on non-bank finance and where official interest rates are hard to cut further. This is where the Fed has already been inventive: printing money to buy all manner of assets. In October it said it would buy short-term commercial paper. This week it unveiled two new schemes: a $600 billion plan to reduce mortgage rates by buying government-backed mortgage securities and the debt of America’s state-sponsored mortgage giants; and a $200 billion scheme to buy the debt backed by credit-card, car, small-business and student loans. This approach could be broadened to other markets that have shut down. For instance, there is little fresh (senior) credit for firms in bankruptcy. If the government can provide that cash, it could stop the coming wave of bankruptcies from becoming one of corporate liquidations.
However, all the bank rescues, credit interventions and looser monetary policy will only get the world so far. The biggest part of Mr Obama’s “jolt”, as he made clear, must be fiscal. When private demand sags so dramatically, the public sector must step in to boost spending, and boldly enough to make a difference. In America, although Mr Obama has refused to give a figure, talk among Democrat bigwigs is of a fiscal boost worth $500 billion-700 billion, or 3-5% of GDP.
So far the only other big country to conjure up sums on this scale is China (and its huge stimulus keeps on having to be revised downward as the figures are checked). Some of the timidity in Europe is explicable: its generous welfare states have more “automatic stabilisers”, such as payouts to unemployed workers, to support economies in recessions than hard-hearted America does. Even so, the Europeans have hardly impressed with their daring.
This week Britain’s chancellor laid out tax cuts worth 1% of GDP, but coupled these with a counterproductive plan to raise income taxes on high earners later. The European Commission has proposed a fiscal boost, across the European Union, of euro200 billion ($258 billion), or 1.5% of GDP, but its proposal seems unlikely to be taken up enthusiastically by member states. Germany, the EU’s biggest country, has both the heft and the money to loosen budgetary policy. Yet the government’s recent boost, amounting to just 0.25% of GDP, hardly suggested urgency.
Plainly, not all countries can afford precisely the same dose of fiscal stimulus. Those reliant on skittish foreign capital have less room to take action than those countries with large amounts of domestic saving. But cautious incrementalism, ironically, risks letting the world slip ever further down the deflationary spiral. It is time to follow Mr Obama’s lead and jolt the patient back to life.