Roubini: Will Aggressive Monetary and Fiscal Measures Prevent Stag-deflation in 2009?

Will Aggressive Monetary and Fiscal Measures Prevent Stag-deflation in 2009?
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Delicious Digg Facebook reddit Technorati RGE Lead Analysts | Dec 12, 2008


Central banks around the world have undertaken a number of measures to forestall deflation and lift the global economy out of economic slump and credit crisis. Aside from traditional monetary policy tools such as official interest rate cuts and relaxations in reserve requirements, central banks have resorted to alternative unconventional tools. Quantitative easing has begun in the epicenters of the credit crisis, U.S. and Europe, who may be joined by other central banks as they too head towards zero interest rates in leaps and bounds (Sweden moved the most in the developed world by 175bp in one shot). With monetary policy transmission broken by the unwillingness of the private sector to lend or borrow, central banks have had to scurry for alternatives to rate cutting in order to restore markets. They set up an alphabet soup of liquidity facilities that lend funds or purchase assets, offered guarantees on deposits and loans, and established currency swap lines, in addition to a host of fiscal stimulus packages announced by governments. Check out “Policy Responses to the Global Credit Crisis”


So are the pieces now in place to prevent global stag-deflation? It is too soon to tell. So far, money market and commercial paper markets have shown tentative signs of easing. But elsewhere in the private sector credit market, tensions remain as asset prices move shambolically and de-leveraging drags on among households, banks and businesses. Though money supply has grown, the velocity of money has slowed despite the flood of liquidity from central banks and official interest rates effectively at or near zero. In other words, we have fallen into a liquidity trap. Such a blow to consumer demand makes deflation in 2009 a real possibility.

Leading the global effort against the credit crisis/recession/deflation are the Federal Reserve and the ECB. Since the start of the crisis, the Fed and ECB have cut a cumulative 425bp and 175bp, respectively. Other central banks in both the developing and developed world have been more aggressive in cutting rates but they started from a higher base or began easing late. In addition to rate cuts, the Fed and ECB have used more targeted measures, setting up new liquidity facilities, asset purchasing programs and currency swap lines, as well as bailing out systemically critical firms and broadening the range of collateral and extending the term of funds lent out at special facilities. Several new programs have been added to the Fed's toolbox since the credit crisis began in August 2007, such as TALF, AMLF, MMIFF, CPFF, TSLF, PDCF, TAF. In October, the Fed began paying interest on reserves deposited at the Fed to allow for essentially limitless balance sheet growth. At the same time, the ECB began offering unlimited cash at its weekly auctions. As a result, the Fed and ECB's balance sheets have exploded.

Despite liquidity raining down on the financial system from the Fed and ECB, the financial fires have yet to be extinguished. Yes, money market rates are off their peaks and the commercial paper market contraction has bottomed. But a lack of confidence among lenders in potential borrowers (and a lack of confidence among potential borrowers given the profit or income outlook) and falling asset valuations has stymied significant easing in market interest rates, such as for mortgages and car loans. Rate cuts and quantitative easing notwithstanding, it seems the threat of a liquidity trap is looming on the U.S. (and the EMU). Central banks still have ammo left to shoot their way out of the trap and forestall deflation. One option is debt monetization: inflating away the public debt from sharp fiscal expansion to stimulate the economy. Bernanke recently brought up the option of Federal Reserve purchases of longer-term Treasuries and agency debt. Check out: “Impact of Fed Rate Cuts and Quantitative Easing” and “Operation Twist: Then and Now”

In the U.S., private demand continues to fall sharply as does the string of awful economic and financial news. The latest employment report surprised on the negative side (with the largest payroll decline since 1974) and job losses are bound to keep mounting. U.S. GDP is expected to shrink 4% or more in Q4 2008 and the contraction is expected to continue throughout 2009. Orthodox and unorthodox monetary policy measures are certainly needed but they have to be accompanied by a significant stimulus on the fiscal side to support aggregate demand. The great retrenchment of the private sector balance is already under way and the new U.S. administration is getting ready to make the largest investment in infrastructure of the last 50 years. The details of the size and content of the stimulus package are not available yet. However, there seems to be a general consensus that a package of $300-$400bn dollars is a lower bound to keep the economy moving,.

Let’s make some back of the envelope computations. The depreciation of the U.S. stock of housing goods brings serious negative wealth effects. According to our computations a 30% fall in home prices peak to trough (and U.S. home prices might very well fall more than that) could result in a negative wealth effect that could subtract up to $400-$500bn from private consumption over time. In the same fashion, a painful rebalancing process that would bring to U.S. saving rates back to the levels of a decade ago (around 6%) would be compatible with a decline in consumption of almost $1 trillion.

It is welcome news that the stimulus package will most likely be in the $500-700bn range and that it will target productive investment in infrastructure, public services and green technology. However, a fiscal stimulus will not prevent a severe recession at this point – the U.S. economy is officially already in recession since Q4 2007 – but will make the recession shorter and less severe than it would otherwise have been.

The EU Commission’s ‘recovery plan’ to be adopted during the EU summit on December 11-12 envisages a fiscal stimulus of around 1.5% of EU GDP or €200bn (approx $260bn). Most of the money will be drawn from national budgets, with EU countries asked to contribute €170bn (approx $221bn) or 1.2% of the EU's GDP. The rest – around €30bn (approx $39bn) or 0.3% of GDP – would come from the EU's own budget and the European Investment Bank (EIB). While some large member states such as the UK and France would like to see a larger common effort to maximize the economic impact and reduce cross-border leaks, Germany looks back at 10 years of hard structural adjustment and highlights the need for each country to keep its own house in order. The same dynamic is also blocking a Common European Bond , which was recently rejected by ECB president Trichet.

Commentators point out that even from a purely domestic perspective, a strong fiscal stimulus is exactly the right medicine for Germany that slipped into recession in Q3 alongside its European partners. Compare the different fiscal packages in Germany, France, Italy, Spain, and the UK.

The United Kingdom is experiencing a large-scale slowdown similar or even worse than the U.S. economy with a deep correction in the housing sector and clear signs of contraction in demand. UK's GDP growth will likely slow towards 1% in 2008 and is expected to contract in 2009. Next year consumption and business investment are expected to drop as the impact of the credit crunch deepens. The government is preparing to pump about £39bn (approx $58bn) into three of the country’s largest banks in a broad-based recapitalization that could see the UK government end up with controlling stakes in RBS and HBOS. The government has been taking major steps to inject liquidity into the system, raising the availability of the Special Liquidity Scheme (SLS) to at least £200bn (approx $296bn) and guaranteeing the issuance of short and medium term debt by banks. The Bank of England (BoE) cut the benchmark interest rate 100 bps to 2.0% on December 4th, the lowest since 1951, after unexpectedly slashing rates by 150 bps early in November, in the wake of what was seen by the central bank “the most serious economic disruption for almost a century”. A fiscal stimulus of £20bn (approx $30b or 1% of GDP) was recently unveiled and a new fiscal rule to improve the cyclically-adjusted level of borrowing every year. Borrowing would rise to £78bn ($115bn) this year and then £118bn ($175bn) in 2009-10 with public sector net debt surging above the current limit of 40% of national income this year, reaching 57% by 2013-14. Part of the spending would be found through £5bn ($7.4bn) in efficiency savings in 2010-11while public spending would be squeezed after 2011 when the growth rate of spending after inflation would be cut from 1.9% a year to 1.2% a year. In addition , value-added tax will be cut from December 1 from 17.5% to 15% until the end of 2009, to make goods and services cheaper and encourage growth, in a move that Mr. Darling described as “a measure to help everyone and deliver a much need injection into the economy.”

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http://www.rgemonitor.com/economonitor-monitor/254748/will_aggressive_monetary_and_fiscal_measures_prevent_stag-deflation_in_2009

I guess if national budget deficits are increasing globally, then the risk is low...

If there is not enough aggregate demand (which there is not), then one solution is for the government to spend money directly into the economy to bolster aggregate demand.

However, in the case of the US, there is a much better solution:
Impose high tariffs on all imported manufactured goods, thus raising their prices in comparison to American-produced goods, and thus increasing demand for American manufactured goods to replace imports.

Oh, that's right. We can't do that. Rich American multinationals would lose money from tariffs, because they'd have to start employing American workers instead of 49¢/hour Chinese workers.

What on earth was I thinking about??
:sarcasm: