Advanced economies have been growing significantly below trend for several quarters despite aggressive policy support. There is a pressing need to find a solution to their slow growth and high unemployment. The short-term answer lies in increasing government expenditure, but medium-term considerations require that the fiscal deficit and debt should be brought under control. In fact, some will argue that even short-term considerations require reduction in the fiscal deficit, as markets might penalise governments by increasing borrowing costs. Interest rates have already risen sharply in peripheral euro-zone countries that do not have a central bank backstop. Their debt dynamics are already unsustainable as a result. However, even in those advanced economies countries that have the advantage of a central bank backstop, when private demand returns and interest rates normalise, debt dynamics could quickly look unsustainable given relatively low potential growth.
Growth in advanced countries is, however, not back on track, as they are growing at only about half the 1994-2003 (pre-boom) averages. Since private demand continues to be weak and monetary policy ineffectual, the International Monetary Fund (IMF) has recently clarified that fiscal multipliers are larger than usual. Not only would fiscal contraction make matters worse, but low interest rates and inflation have created the fiscal space to continue with stimulus measures. There have, of course, been episodes of “contractionary expansion” in the past, but this looks unlikely in a synchronised recession and fiscal tightening.
The G20 and IMF recipe for resolving this policy dilemma is that those countries that have fiscal space must stand ready to continue with fiscal stimulus, should conditions deteriorate. It is not clear what countries that do not have this space, mostly in the euro zone periphery, should do in the circumstances. A comprehensive restructuring of the euro zone, currently under negotiation, combining fiscal and banking integration, central bank backstops and mechanisms for fiscal transfers, is necessary in such cases.
It is also not clear how short-term and medium-term objectives should be harmonised. In real life, the short term and the long term are part of the same continuum. What policy makers, therefore, need is a road map with clear signals along the way that would enable them to move seamlessly from the short to the medium to the long term.
In particular, policy makers need to know when to start exiting from extraordinary policies currently in place. They should be open to the possibility that a return to former growth rates may not occur on account of a permanent loss in demand. Policy makers should, therefore, not be looking at growth, but at treasury yields and inflation. These could be the canaries in the goldmine signalling the revival of animal spirits and closing of the output gap. At that point monetary policy would need to take over the mantle of macroeconomic stabilisation from fiscal policy, finely balancing the need to anchor inflationary expectations on the one hand by gradually normalising interest rates and unwinding unconventional monetary measures, while gradually inflating away high levels of public debt through some degree of financial repression on the other.
Operationally, macroeconomic policies may need to pass through four broad stages to balance conflicting short-term and long-term objectives. The first stage – the present – would consist of continued fiscal stimulus and easy monetary policies.
Rising yields on sovereign bonds and/or inflation would be the first signal of the return of private demand and stability in financial markets, and the narrowing of the output gap. In this second stage the withdrawal of fiscal stimulus should be calibrated and gradual, so as not to choke off the incipient recovery. The mantle of stimulus would also be increasingly borne by monetary policy, which would remain easy although unconventional methods such as quantitative and credit easing, which suppress market signals relating to government borrowing costs, would need to be phased out.
In the third stage, when the recovery is secure and robust, fiscal consolidation should be accorded top priority. During this phase central banks may need to keep interest rates low not simply to support the recovery but also to assist in fiscal consolidation. Given the combination of high levels of public debt and low trend growth, there may be little option but to inflate part of the debt away by keeping real interest rates negative to stabilise debt.
The fourth stage would be when policy makers have the confidence that debt dynamics have stabilised. This would mark a normalisation of interest rates and return to conventional, rule-bound monetary policies, such as the Taylor Rule.
The rollback of central bank balance sheets would have to be deftly managed. Unconventional monetary policies have led to a sharp increase in the monetary base. As private demand picks up, large amounts parked by depository banks with central banks would go back in circulation as the money multiplier returns to more normal levels. This could be inflationary, unless the central bank shrinks its balance sheet and soaks up the excess money in circulation. The rollback of the balance sheet could be measured and calibrated in the third phase to keep real interest rates slightly negative, while anchoring inflationary expectations. Be it as it may, in view of the huge expansion in their balance sheets at a time of rock-bottom interest rates, unless deftly managed central banks may be constrained to book huge capital losses in the process. This burden would ultimately need to be passed on to the taxpayer through the Budget.
The austerity-growth policy equation in developing countries is quite different. For example, in India, growth has slowed but inflation remains high. On the one hand, this is constraining the space for monetary policy. On the other hand, the imperative for fiscal consolidation is greater and immediate. This is not on account of possible market revolt – despite high deficits debt/GDP ratios have scarcely changed – but to avoid crowding out of private demand and reducing interest payments as a proportion of revenue.
C Rangarajan and Alok Sheel are Chairman and Secretary respectively of the Prime Minister’s Economic Advisory Council. These views are their own