Wednesday, 27 January 2010

Obama Freeze

(The past two months I have been working on some exceptionally interesting problems, and hence the absence from the blog. Here is one to the 'dear readers' who bugged me to return.)

Fascinating it is to see the way our thinking evolved about the 'optimal' policy behaviour in a crisis. You could argue that before the meltdown of September 2008 we all thought that the way to deal with recession was to tighten fiscal policy quite a lot and loosen monetary policy a bit. Surprise came when this crisis unfolded in a way that made the monetary transmission mechanism disappear and thus apart from some unorthodox (aka we have no idea what will happen) liquidity moves, the central banks were out of the picture. Predictable policy panic followed. In an economics universe where Ricardian equivalence rules, fiscal expansion would only make things worse. (Footnote: some qualifications remain. As always...) So we all got terribly surprised when the panicked fiscal stimuli of spring 2009 seemed to have worked.


Except, that we’re not quite sure whether it was the fiscal stimuli that worked. In fact we are not even sure that something worked. The global economy seems to be coming out of recession in a way that could be easily interpreted as a short lull.

However while we don’t really know what is going on with the real economy in any country that might matter for the global dynamics, should it be the US, Germany or China, there is one piece of good news that seems fairly certain. The banking sector that was (or: happened to be) the trigger of the recession has been sorted out. Well, at least domestically, and at least it is some of the countries …

The upshot is, that the banking sector is back into the business of channelling the central bank’s will. It might thus make sense to go back to the bit of economics that worked before the crisis, and probably would have worked during the meltdown. Stimulate the economy via a low interest rate environment, and at the same time make space for looser monetary policy by tightening the government budget. In other words, Obama’s proposal -- attacked by many US analysts as a mere political move -- might make a lot of sense.

(It is especially funny to see the Obama move being attacked by the very same people who despised the fiscal stimuli at its birth. The conservative mindset combines well with a short memory span...)

This is not to say, that if the banking crisis was not the illness, but only a symptom of the underlying problems, the global economy would still be out of water. The argument suggesting that the lack of global action will lead to even higher tension and thus possibly even more severe crises still holds. But the day of that Great Meltdown might just be postponed. And, if other governments follow suit, you might even regard that as a somewhat harmonised global fiscal policy stance.

(For a brilliant comparison between the global pickle we are in now, and the Japanese pickle a decade ago, have a look at the paper Lost Decade in Translation: What Japan's Crisis could Portend about Recovery from the Great Recession. The bottom line: no amount of fiscal and monetary policy wizardry will work as long as the underlying structural causes of the malaise are around. -- We just need to agree about those then...)