The Fire Is Still Burning

Op-ed in Handelsblatt

October 13, 2010

The current macroeconomic policy discussion is mostly missing the point. Our situation-in the United Kingdom, the United States, and arguably in most of Western Europe (though possibly not Germany for now)-is one where policymakers face a long, uphill battle. In this battle, monetary ease has an ongoing role to play, even if it may not deliver recovery on its own. Insufficient monetary stimulus and excessive fiscal austerity risks turning sustained low growth and near deflation into a self-fulfilling prophecy. That is what happened in Japan in the 1990s and in the United States and Europe during the 1930s. I do not expect an outright depression, and perhaps growth will remain on average positive for the next few years. We do face, however, a real risk of long-term stagnation, which over time slowly erodes our economic capacity and even our social stability.

The danger is that policymakers will repeat the mistake of the 1930s, not the mistake of the 1970s-that is, policymakers will tighten unnecessarily by underestimating potential growth.

There are not finely balanced risks between overheating on inflation and a short-term double-dip recession. That is the fine-tuning thinking of the past decade, which many European policymakers have rightly criticized in the past, and certainly is wrong now. The short-term up and down blips in the economy are no way to judge whether we are avoiding the risks of settling for damagingly insufficient growth. We saw similar starts and stops during the Great Depression and in Japan's lost decade. We would have had to see inflationary pressures from overheating and rising interest rates from high investment demand to indicate that we are in a different kind of recovery than the bad kind. We have not seen any such indications.

The danger is that policymakers will repeat the mistake of the 1930s, not the mistake of the 1970s-that is, policymakers will tighten unnecessarily by underestimating potential growth. How could the inflation of the 1970s be repeated? Wage growth in the private sector is well below productivity growth, and public sector wages and employment will be cut substantially for the next few years. It seems impossible to have an upward wage-price spiral under such circumstances. Instead, we need to recognize that if we engage in insufficient stimulus, then aggregate supply and productivity will get worse-not only through the evident worsening of labor market matching, but through banks cutting off loans to new and small businesses, and investment in research and in infrastructure being cut.

In terms of how to do more, there has been too much obsession with the scale of central bank balance sheets and even of government debt levels (outside obviously of Greece) as a constraint. This confuses means with ends. It is backward logic to say that because central banks have bought more assets than ever before, either we must have already done enough or our stimulus efforts must be fruitless. That is like saying, "that fire must be out because we've already pumped more water on it than for any previous fire we've fought before." Yet, the real issue is this is a far larger fire than any of us have fought in our lifetimes, and the flames are not out yet.

The most likely reason monetary stimulus would be insufficient on its own to bring sustained recovery is the ongoing fragility of the financial system. This limits the effectiveness of monetary stimulus by restricting lending to new and small businesses. Having some day-to-day financial stability due to guarantees is not the same as having a fully functional banking system-the proof of functionality is in the type of lending undertaken, not in stress tests.

The German economy may not be at high risk of this kind of stagnation right now, taken on its own terms. It has responded extremely well to an external demand shock and global export recovery, despite ongoing banking problems. The long-overdue real wage increases for deserving German workers that are underway are the best possible domestic contribution to Germany's own economic prospects, as well as to those of the world. But Germany is not the only economy in the euro area, and its relative strength should not be used as an excuse for settling for too little growth in its neighbors.

Ultimately, doing more monetary stimulus and not overdoing the speed of budget consolidation is the right move for the long term-this is not about impatiently preventing a double dip. Doing more would prevent erosion of our productivity and work force, and forestall (I hope) falling into a self-fulfilling trap. It also is an important insurance policy against political illiberalism and protectionism arising. It is just as important to future generations that we deliver them an intact democratic system and liberal world economy as it is to consider the more commonly spoken of debt-burden concerns.

Adam Posen is a senior fellow at the Peterson Institute for International Economics and an external member of the Bank of England's Monetary Policy Committee. The views expressed here are solely his own, not those of the Bank, the MPC, or PIIE.