It may strike you as extraordinary that the G20 summit barely touched on what is, arguably, the key policy issue going forward – what will central banks do, including the detailed when and how of avoiding falling wages and prices (deflation). Fiscal stimulus is already almost fully in play around the world, regulatory reform will at best be slow and not relevant to the recovery, and “we promise to avoid an irresponsible protectionist trade war” is nice but more about not making things worse rather than getting our economies going again. Funding and leadership model change for the IMF can help prevent emerging markets from cratering, but in terms of impact on global growth or unemployment, it’s second order relative to the macro policies of the world’s largest countries.
The real issue is monetary policy, including interest rate cuts where there is still room for these – to me the biggest news of the week was actually that the European Central Bank cut rates by less than expected (its main interest rate stands at 1.25 percent). This confirms the ECB still does not see deflation as a clear and present danger. Look at all the downward pressures in the European economy, from East European collapses (and associated West European banking problems) to property market declines in the UK, Ireland and Spain (and what that means for banking) and export industry stress (and they have bankers too). The ECB is taking an extraordinary and – to my mind – incorrect position. If they truly wait until deflation is “fully in the data” (central bank jargon), it will be too late.
The dramatic trans-Atlantic, or at least eurozone-dollar, contrast is in terms of monetary policy, not fiscal stimulus or attitudes towards future regulation. In our piece in the Washinton Post Outlook section on Sunday (already online), we provide an updated back story on how exactly the Fed and its chair got to the point of taking bold and unprecedented moves towards expansionary monetary and credit policy.
In our view, the Fed’s current “print the money” strategy (and, yes, I know the Fed doesn’t like this term or even “quantitative easing”) is make-or-break for turning the economic corner any time soon. It’s incredibly risky in terms of potential inflation – more than the Fed would ever concede – but preferable to all the available alternatives.
The power of our big banks presents a profound economic and political problem. Whatever happens – miraculous recovery or prolonged depression – this needs to be fixed. But we also can’t wait around for attempts to break up the banks; the prospects for unemployment and poverty are too dire to tolerate delay. First and foremost, we need to prevent global deflation and begin the difficult process of sustaining a recovery.
Remember this. If you run an expansionary fiscal policy (building bridges), I have an incentive to free ride (selling you BMWs) and not engage in a similar fiscal stimulus. But if you run an expansionary monetary policy, your exchange rate will tend to depreciate, putting pressure on my exporters and I’ll be pushed – by BMW-type producers – towards providing a parallel monetary stimulus.
There is only one person who can talk the ECB out of its current, ruinous policy: Ben Bernanke.
By Simon Johnson
Update (by James): This article has gotten a fair amount of commentary already.
- Mark Thoma says it depends on whether inflation expectations remain anchored (at 2%, where the Fed wants to peg them).
- Tim Duy says that we are making the mistake of confusing “credit easing” with “quantitative easing.” Duy points out (correctly) that Bernanke has repeatedly insisted that the Fed will mop up the excess money when necessary in order to dampen inflation; this means that the Fed is trying to keep inflation expectations where they are, despite the influx of money now. This could be Bernanke’s intention, but I think there’s still a question of whether the Fed will be able to follow through when necessary, and the resulting uncertainty could itself feed inflation expectations.
One thing I want to clarify, which Simon says above but is perhaps not clear in the article, is that we do not think that Bernanke is making a mistake. We think that despite the inflation risk, this is still the right strategy, because of the risk that the other tools used to restart the economy may not have sufficient oomph.