Some voices have prematurely claimed that the economy is on its way out of the crisis and getting back to normal. The recent speech of FED chief Ben Bernanke and newly emerging turmoil in European sovereign debt markets suggest that dark clouds might still persist on the horizon. Taking the sub-prime mortgage meltdown in mid 2007 as a starting point most of the industrialized world has been in economic troubles for almost three years now. What has been done to solve the crisis? A lot and nothing at the same time. To be fair to policy makers, it must be conceded that a Great Depression style abyss has been prevented. However, the debt problem has merely shifted from the private sector to the public sector and the mess has not been cleaned up.
One essential part of the current crisis is that many people thought they were richer than they actually are. The financial collapse has made this quite evident. Imagine an economy with a more or less fixed amount of wealth. Modern economies have become so complex that the actual ownership of this wealth is not immediately obvious to everyone. Individuals hold bonds, stocks, cash, derivatives, to name just some. If, as happened in the recent crisis, those claims where as a whole overvalued and people therefore thought they are richer than they actually are, some individuals will have to lose claims on real assets. The question is now which parts of the economy will pick up the mess and give up on their perceived wealth.
Next to the question who will lose is how fast the process will be carried out. This is the more essential challenge and to put it simple, the faster the better. Recent economic history has two prominent examples on the extreme ends of debt resolution. Sweden has chosen the fast way and Japan gone down a long and dragging path. While Japan's lost decade might soon amount to twenty years of foregone economic growth, Sweden has recovered quickly and gone back to business as usual. My guess is that both Europe and the U.S. will not end up quite as bad as Japan, but the tendency goes towards it at the moment. Policy makers will most likely choose too start loosening monetary policy in ways not seen before in order to prevent a Fisher-type deflation spiral at any cost. This will, if successful, not solve the initially mentioned problem that certain economic agents have to give up on some of their claims. Overly loose monetary policy will only create high inflation, possibly the lesser of the two (inflation/deflation) evils. Overall, this hardly allows for a positive outlook on the economy.
