The University of Copenhagen's professor of international economics evaluates stimulus policies and explains why it is time to start implementing exit strategies from them, despite the doubts that remain over the recovery.
As the economic recovery from the steep decline of 2008-09 continues and forecasts for 2010-11 are gradually being revised upwards, the talk of so-called 'exit strategies' intensifies. There is a general recognition that the policy stimulus undertaken in nearly all countries has been so extraordinary that the case for persisting has to be re-examined. But, quite understandably, any such examination is beset by agonising doubts as to when and how to exit.
There are three reasons for such doubts: the recovery is still seen as relatively fragile; there are complex interactions between the three types of policy stimulus introduced - fiscal, monetary and financial; and international co-ordination of national efforts is seen as desirable but difficult to achieve.
This article argues that it has, indeed, become high time not only for designing exit strategies, but also for beginning to implement them, and that central banks have a special responsibility in this process. In doing so, it is necessary first to squarely confront the three sources of doubt about exit strategies.
The three doubts
Does the recovery remain too fragile? It clearly has some way to go. Although 2009 ended on a much better note than expected, all important economies, with the exception of China and India, are well below the trend growth paths observed over the past decade or so. The general perception is that output growth in the Organisation for Economic Co-operation and Development area will at best recover to a trend parallel to, but a few percentage points below, the earlier path, but doubts remain as to whether past rates of growth will again be observed.
In particular, unemployment rates are still rising. In the US, the rate is projected to peak soon at a level of just above 10%, or about twice the level seen as compatible with stable inflation a few years ago. Just to absorb new entrants into the labour force requires the creation of more than 1 million jobs a year.
In Europe, the level of (measured) unemployment is lower, but seems more stubbornly stuck. Some countries, notably Germany, have deferred the impact of the downturn on employment through shorter working hours, while other countries face rates that are already far above the European average. The perception that more time is needed to heal the wounds of the downturn is the single most serious constraint on the implementation of exit strategies. The recovery no longer appears especially fragile but it has a long way to go to absorb the under-utilisation of resources in most industrial countries.
The sequencing of exits from fiscal, monetary and financial stimuli is another major cause of doubt. The stimulus provided has been extraordinary in all of its three dimensions and the interactions between them pose additional complications for exit strategies.
Public sector deficits are currently running at more than 6% of gross domestic product in most countries in the euro area and at about twice that rate in the US and the UK. These deficits are not just the result of cyclical downturns: they indicate the emergence of exceptionally large structural deficits.
Short-term policy interest rates are virtually zero in the industrial countries, and slightly negative in real terms. Longer-term interest rates have also become very low, partly by assuring markets that short rates will be kept low for some time and partly by outright central bank purchases of government bonds or other securities.
Central banks have introduced new borrowing facilities on an unprecedented scale, hugely inflating their balance sheets. Finally, financial institutions have received massive support of public funds through the purchase of some of the risky assets held on their balance sheets and by outright recapitalisations.
Co-ordinated response
While nearly all of these measures were regarded as necessary, it is equally clear that they are not sustainable in the long-term. The level of public sector indebtedness has replaced that of households as the major concern; consolidating the financial position of households was necessary and could not have been achieved without a major worsening of public budgets, but for how long? And what is the proper sequence of measures to begin a withdrawal of the three dimensions of policy stimulus?
Central bankers are hinting that those responsible for fiscal policies should act first, but governments are hesitant to take on the risks in electoral terms of exiting early. The public debate on sequencing is also marked by the readiness of policy-makers to put the blame for the crisis predominantly on the financial sector. Irresponsible risk-taking, prompted by distorted incentives and overambitious leverage, were indeed important elements in understanding the crisis, but macroeconomic policies in the shape of very low interest rates and lax fiscal policies established the necessary conditions for asset price bubbles financed by rapid credit growth. However, the public's perception was that the financial sector was the prime culprit.
In order to avoid repeating the experience, the first exit from extraordinary stimulus should, from this perspective, rein in the capacity of the financial system to expand credit through higher capital requirements, extending regulation and capping bonuses.
National policy-makers are also waiting for their colleagues in other countries to act. Some policy actions were internationally co-ordinated when the crisis struck in the autumn of 2008, notably important cuts in interest rates. But the case for co-ordination is weaker in the fiscal area; spill-over effects are more limited and the initial budgetary positions as well as international imbalances call for differentiated rather than parallel actions. As governments continue to debate when to exit, the perception of having successfully acted together during the downturn appears to support repeating co-ordinated measures when exiting.
The case for not delaying
Despite the three doubts about exit strategies discussed above - of which the first is by far the best-founded - there are strong arguments for designing such strategies in more detail now and beginning their implementation this year. It would not be appropriate to simply withdraw support to the financial sector and introduce additional regulation, however popular such action may seem. In particular, financial institutions are highly unlikely to be in a position to repeat earlier excessive risk taking. A gradual phasing-in of the higher capital requirements envisaged for banks, while permitting the credit growth necessary to sustain private investment, should be sufficient as a financial exit strategy.
Ideally, fiscal consolidation should be the first priority, given the extraordinary projections for debt accumulation. But, realistically, governments are unlikely to reduce deficits in 2010, except to allow for better revenue growth than projected some months ago. Such modest automatic stabilisation will have to be much reinforced when budgets for 2011 are drawn up with the effort directed at consolidation measures that are the least unfavourable to economic growth. The governments in the EU, now in almost uniform violation of their commitment to avoid 'excessive deficits', may find it an irritant in the current economic climate to have to present consolidation plans in some detail. They should see the process as a positive one which distinguishes the EU from other major economies where considerations of the sustainability of public finances are more remote from the policy debate. Budget consolidation will have to be highly differentiated, with the eurozone countries affected by recent losses of confidence acting much more swiftly than others.
In the absence of major exits in the two other policy dimensions, the central banks will have to take initiatives to begin to implement an exit strategy for which the contours have become more visible. First to come is the exit from the most unorthodox policies in the form of direct purchases of longer-term securities ('quantitative easing' or QE) and liquidity support through special facilities beyond the very short term. Central bank policy has two important tasks: to offset shifts in the demand for excess reserves in the financial system and to conduct an interest rate policy which helps to stabilise the real economy. QE and longer-term facilities were justified when the seizure of money markets drove up the demand for reserves but now these exceptional measures could be withdrawn.
Later, but still in 2010 on current projections, the time will also come for beginning the exit from very easy monetary policy. This will require great care in communication, since inflation as measured by consumer prices will still be projected to run below 2% which has come to be seen as an acceptable rate over the relevant horizon - and with a significant output gap. A monetary exit strategy will also be seen as a break with a relatively rules-based strategy for which central banks have obtained credibility and as a departure for a more discretionary monetary policy. Such a shift, however gradual and well-justified, will require careful communication, since central bank independence may be endangered by the additional discretion, which the current challenge warrants. This is a risk that central banks should accept.
Niels Thygesen is professor of international economics at the University of Copenhagen and was an architect of the European economic and monetary union.
