A short Note on the long Run

Last year I was questioning the potential of the world economy to come out of the financial crisis induced recession any time soon. Today, most countries are technically not in a recession anymore. Rubini and others have been warning of a “double-dip” recession and some countries show first signs that this might indeed be the direction we are headed.

The costs of getting out of this recession have been tremendously high. A relative stabilization has been achieved by unprecedented monetary (close to zero interest rates and quantitative easing – the modern form of printing money) and fiscal stimulus. The loose monetary policy can be upheld basically forever (see e.g. Japan over the last two decades), if inflation tendencies are neglected (see also the new IMF proposal of raising the central bank target rate to 4 %). Fiscal policy instruments have been overstretched and if anything budget cuts lie ahead at least in the middle run. The markets have started focusing their attention on sovereign debt and will monitor every step of troubled states closely. Even supposedly strong countries such as Germany are actually in fiscal troubles, it is just forgotten over others being in far worse crisis modes. As a result, fiscal stimuli will be withdrawn and probably reversed sooner or later (especially due to the increasing headwind when it comes to further lavish fiscal expansion). Forget about returning to normal times in terms of monetary policy, monetary policy will have to remain as loose for quite a while simply to prevent a further slump.

Europe and the U.S. have only started to deleverage and mostly redistributed the debt from the private sector to the public sector. While private households can simply decide to save and in that way reduce demand in the economy, debt-financed government spending increases demand instantly. This has bought some time, that is all. Deleveraging means saving and that for an extended period of time and it will need to be done sooner or later. It might take a decade or longer and no democratically elected politician hoping for re-election will admit that. There is no free lunch and an extended period of economic weakness lies ahead. How long it takes depends on how fast deleveraging will proceed and it seems likely that it will be slow. The U.S., although current problems seem slightly bigger, might grow out of it somewhat quicker than the less dynamic European economies.