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In these difficult circumstances, calls for further economic stimulus are not surprising. Some advocate additional monetary accommodation; others suggest a softening of the new financial regulatory regime; and still others recommend postponing fiscal consolidation and structural adjustment in the private sector until happier times. The common basis for all of these proposals is that, if only policymakers were less rigorous and stimulated more now, growth would eventually come to the rescue. If only it were that simple!
The main roadblock to sustained growth is not a lack of economic stimulus. Instead, it is a vicious cycle of adverse feedbacks between three fundamental weaknesses, all related to balance sheets:
Central banks find themselves caught in the middle, forced to be the policymakers of last resort. They are providing monetary stimulus on a massive scale. They are supplying liquidity support to banks unable to fund themselves in private markets. And they are easing government financing burdens by keeping interest rates low far out along the yield curve. These emergency measures could have undesirable side effects if continued for too long. A worry is that monetary policy would be pressured to do still more because not enough action has been taken in other areas. While central bank actions can buy time, they cannot substitute for balance sheet repair or reforms to raise productivity and growth. Central banks cannot solve the problems neglected by other policies.
The current difficulties of the world economy have deep roots and will require fundamental solutions. Fiscal adjustment, the repair of banks’ balance sheets and other reforms cannot be put off in the hope of better times. Relying only on central banks but failing to act on other fronts would ultimately damage confidence and increase the risks to macro-economic and financial stability.
The pace at which countries close fiscal deficits, and phase in reforms, depends on their individual circumstances. Those with the weakest fiscal positions and highest dependence on foreign funding will have to move quickly. Most advanced economies do not have the luxury of waiting. Fundamental fiscal reforms are needed at all levels of government.
Simultaneous fiscal adjustment across many countries would impose special responsibilities on countries that have a current account surplus and are too dependent on exports. Through structural and other reforms, they can re-orientate their economies to increase domestic absorption and achieve more sustainable growth in the long run. This would help other countries reduce their unsustainable current account deficits.
Strong demand in several emerging economies has helped support global demand in this crisis. But even these dynamic economies cannot always rely on further macroeconomic stimulus. Some are also exposed to the kind of credit-driven expansion that did so much damage in advanced economies. Finally, some remain vulnerable to sudden reversals of external financing.
Achieving strong and sustainable growth also depends on strong international cooperation. In tackling the root causes of the crisis, implementing reforms and resisting national bias is essential. Although the progress already achieved – including in those countries now under stress – should not be underestimated, it will take time for the benefits to materialise. In the meantime, we must build on this progress and complete the job if we are to restore confidence and reinforce the basis for sustainable growth.