Economic policy in the developed world over the past 25 years has followed one overriding principle: the avoidance of recession at all costs. For much of this period monetary policy was the weapon of choice. When markets wobbled, central banks slashed interest rates. A by-product of this policy was a series of debt-financed asset bubbles. When the last of those bubbles burst in 2007 and 2008, the authorities had to add fiscal stimulus and quantitative easing (QE) to the policy mix.
The subsequent huge rise in budget deficits was largely the result of a collapse in tax revenues that had been artificially inflated by the debt-financed boom. Britain and America ended up with deficits of more than 10% of GDP, shortfalls that were unprecedented in peacetime.
Those deficits may have been necessary to avoid a repeat of the Depression. Economists will probably still be debating this issue in 75 years’ time, just as they still discuss whether Franklin Roosevelt’s New Deal programme was effective in the 1930s. But the “shock and awe” approach to Keynesian stimulus has an unfortunate consequence. Any decline in the deficit, even to a still whopping 8% of GDP, acts as a contractionary force on the economy: either the government is spending less or taxing more.
As a result governments are reluctant to cut the deficit too quickly for fear of sending their economies back into recession. But unless there is a rapid recovery, the debt will keep piling on, making the ultimate problem harder to solve.
Turning to monetary policy, interest rates are 1.5% or below in most of the developed world and are negative in real terms (the Bank of England kept rates at 2% or more for the first 300 years of its existence). In a normal recovery central banks would be looking to increase rates from crisis levels by now. But high debt ratios (particularly in the household sector) make central banks very uneasy about raising interest rates for fear of ushering in another round of the credit crunch. With the big exception of the European Central Bank, most have repeatedly postponed the moment at which monetary policy is tightened. The parallels with Japan, where interest rates have been at rock-bottom for a decade, are striking.
As for QE, it is hard to tell how successful it has been as a strategy in reviving the economy although it certainly seems to have helped to prop up equity markets. Central banks seem reluctant to push it much further at the moment. But there is no suggestion that the economy is strong enough for them actively to unwind the policy by selling assets back to the markets.
In all three cases the story is the same. Governments and central banks have thrown a lot of stimulus at the economy and the result has been a fairly sluggish recovery. They have painted themselves into a corner. They cannot go forward, in the sense that there is little political or market appetite for more stimulus. But it is also hard for them to go back. Read more.
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