Greg Ip

Articles by The Economist’s U.S. Economics Editor

Typically constrained policy

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Mar 25th 2011, 19:18 by G.I. | LONDON

[Greg Ip] THE failure of the American economy to achieve meaningful liftoff is too easily explained away by special factors. My colleague acknowledges this, yet wonders whether post-crisis recoveries by their nature have to be weak:

[G]rowth has been slower than it otherwise would have been thanks to tighter than necessary fiscal and monetary policy.

I think this sort of misses the point. The fact that post recoveries are weak is anempirical observation. They are principally weak because the financial crisis is caused by the buildup of leverage. The process of deleveraging weakens the potency of monetary policy (even low rates won’t persuade people to borrow if they want to cut their debts or banks are too crippled to lend). Thus, the central bank either runs out of ammunition before it can adequately restore demand, or is constrained by a nominal anchor such as an exchange rate peg (in which case easy monetary policy could lead to devaluation, inflation and a rise in external debt).

As Rogoff and Reinhart have demonstrated, the crisis usually also leads to a dramatic increase in the budget deficit and a rise in the debt to GDP ratio. Stimulus is one, but not the major, contributor to the increased debt. But the rise in debt to dangerous levels naturally makes the fiscal authority reluctant to take on more debt.

If the central bank and fiscal authority had complete confidence in the efficacy of unconventional monetary policy or extreme fiscal policy, or were unconstrained by political considerations, they would use whatever means were necessary to boost demand to more acceptable levels. But typically, they don’t, and they aren’t. That is one reason post-crisis recoveries are weak.

The original article is linked here.


Written by gregip

March 25, 2011 at 3:12 pm

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