2011 In Review: Four Hard Truths, by Olivier Blanchard: What a difference a year makes …
We started 2011 in recovery mode, admittedly weak and unbalanced, but nevertheless there was hope. ... Yet, as the year draws to a close, the recovery in many advanced economies is at a standstill, with some investors even exploring the implications of a potential breakup of the euro zone, and the real possibility that conditions may be worse than we saw in 2008.
I draw four main lessons from what has happened.
•First, post the 2008-09 crisis, the world economy is pregnant with multiple equilibria—self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.
Multiple equilibria are not new. We have known for a long time about self-fulfilling bank runs; this is why deposit insurance was created. Self-fulfilling attacks against pegged exchange rates are the stuff of textbooks. And we learned early on in the crisis that wholesale funding could have the same effects, and that runs could affect banks and non-banks alike. This is what led central banks to provide liquidity to a much larger set of financial institutions.
What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets—largely future tax receipts. If investors believe they are solvent, they can borrow at a riskless rate; if investors start having doubts, and require a higher rate, the high rate may well lead to default. The higher the level of debt, the smaller the distance between solvency and default... Without adequate liquidity provision to ensure that interest rates remain reasonable, the danger is there.
•Second, incomplete or partial policy measures can make things worse.
We saw how perceptions often got worse after high-level meetings promised a solution, but delivered only half of one. Or when plans announced with fanfare turned out to be insufficient or unfeasible.
The reason, I believe, is that these meetings and plans revealed the limits of policy, typically because of disagreements across countries. Before the fact, investors could not be certain, but put some probability on the ability of players to deliver. The high-profile attempts made it clear that delivery simply could not be fully achieved, at least not then. Clearly, the proverb, “Better to have tried and failed, than not to have tried at all,” does not always apply.
•Third, financial investors are schizophrenic about fiscal consolidation and growth.
They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.
I should be clear here. Substantial fiscal consolidation is needed, and debt levels must decrease. But it should be, in the words of Angela Merkel, a marathon rather than a sprint. It will take more than two decades to return to prudent levels of debt. There is a proverb that actually applies here too: “slow and steady wins the race.”
•Fourth, perception molds reality.
Right or wrong, conceptual frames change with events. And once they have changed, there is no going back. For example,... not much happened to change the economic situation in the Euro zone in the second half of the year. But once markets and commentators started to mention the possible breakup of Euro, the perception remained and it also will not easily go away. Many financial investors are busy constructing strategies in case it happens.
Put these four factors together, and you can explain why the year ends much worse than it started.
Is all hope lost? No, but putting the recovery back on track will be harder than it was a year ago. It will take credible but realistic fiscal consolidation plans. It will take liquidity provision to avoid multiple equilibria. It will take plans that are not only announced, but implemented. And it will take much more effective collaboration among all involved.
I am hopeful it will happen. The alternative is just too unattractive.
As Krugman notes here and here -- the former memorable for the line "there is a sanity clause" -- the IMF wasn't as crazy as the ECB and the OECD (and policy elites more generally) on the austerity issue:
...the [IMF] report takes on Alesina-type studies, which have been heavily promoted... The IMF basically finds them all wrong, largely for the reasons I have pointed out in the past: their methodology does a really terrible job at identifying actual changes in fiscal policy. ... And it turns out that identifying the episodes right reverses the results: contractions are contractionary, after all.
However, while sanity may have prevailed on fiscal policy, the lack of comments on monetary policy -- particularly as it relates to the euro and the ECB -- is notable. Blanchard has, in the past, called for higher inflation targets and more aggressive policy, and I doubt it's an accident that this is omitted from his comments. There are vague references to this, e.g. "Without adequate liquidity provision to ensure that interest rates remain reasonable, the danger is there," but nothing specific. I think there's a big lesson to be learned about what can happen if a central bank refuses to act as a lender of last resort, and would have liked to have seen something along these lines included among the bullet points.