Restoring confidence yes, but don't ignore the long term

Posted by Eswar Prasad on 30 January 2009

Editors’ note: Oliver Blanchard’s “Economics Focus” on fixing the crisis asserts that eliminating uncertainty is the key to ending the crisis – an argument advanced in more detail by his colleague Ricardo Caballero on Vox last week. The Economist’s blog, Free Exchange, has invited a number of comments from eminent economists; GCD reproduces them here (with permission). The full thread of Blanchard posts can be followed here.



Restoring confidence is key

Restoring confidence is a key to economic recovery. In his column, Olivier Blanchard makes a persuasive case that uncertainty about the economic environment is stifling aggregate demand—both consumption and investment. This in turn weakens output growth, reinforcing the lack of confidence and setting off a downward spiral.

Indeed, the tail uncertainty – namely the thought: “What’s to keep the Dow from falling to 6,000 and unemployment going to 10% or worse” – is particularly nerve-wracking for American consumers, whose borrowing and spending habits helped sustain world growth. Mr Blanchard therefore recommends that the government take steps to reduce tail uncertainty and give consumers direct incentives to, well, consume. But it is unclear whether these steps will be sufficient to motivate American households to return to their old ways, especially now that their housing and financial wealth has collapsed, along with job prospects.

Mr Blanchard argues that the government should directly revive the market for risky assets. He makes the intriguing suggestion that, since the world loves American Treasury bonds, the American government should issue even more bonds and use the proceeds to buy domestic assets and also recycle part of the funds to emerging markets. Picture this: America’s government not just running industrial policy by picking winners and losers in the America, but also picking global winners and losers! I am, of course, caricaturing his caricature, but you can see where this might lead.

Do we have a choice? Fine line between panic and concerted action

It is a sign of how desperate the times are that many such ideas, which might seem harebrained in normal times, now come under the rubric of creative and useful solutions. I applaud Mr Blanchard for having the intellectual courage to put all of them, no matter how unorthodox, on the table. And he is surely right that decisive and massive intervention on all fronts – using fiscal, monetary and financial measures – is a necessity.

There is, however, a fine line between panic and concerted action that policymakers will need to think about when using measures to reduce uncertainty. Blanchard is correct in implicitly focusing on whatever it takes to put the global economy back on its feet – we can worry about its long-term health later, when we have the luxury of doing so. But someday the sun will shine again. And there will be a price to pay for massive government intervention now, which will almost certainly lead to more reckless behaviour in the future, once greed again gets the upper hand over fear. Still, the long term seems a distraction now.

One reason to focus on the long term, however, is precisely to remove long-term uncertainty and the perception that today’s remedies might lead to more bitter medicine in the future. It is also important for policymakers to send a strong signal that their measures are considered ones and are not merely mortgaging the future for the present. Spending on public infrastructure, for instance, falls into this category – the short-term stimulus would feed into longer-term productivity gains. Unfortunately, the lack of emphasis on infrastructure spending in the past few years means that America has relatively few shovel-ready projects, which will delay the short-term impact. We need other creative solutions that tie together short-term stimulus with longer-term benefits.

Global coordination of fiscal stimulus

Mr Blanchard has made the point in other forums that global coordination of policies, especially coordinated fiscal stimulus in major economies, is necessary to revive world growth. Indeed, such coordination, if suitably trumpeted and implemented on a massive scale, could deliver a much bigger bang for the buck than uncoordinated policies. But it is equally important for leaders of the major advanced and emerging economies to follow through on their commitment to avoid protectionist policies.

The China-America spat on currency and trade issues, which has heated up enormously in the last week, certainly does no good for confidence in the world trading system at this precarious moment. This dimension of uncertainty is particularly harmful for investment, especially in the more dynamic job-creating traded goods sectors.

Mr Blanchard asks policymakers to do a lot. But aren’t perceptions of uncertainty malleable and important as well? Don't they have real consequences? Here the media plays a role – it has an inherent bias towards reporting and highlighting bad news, which is especially unhelpful in these difficult times. The drumbeat of sobering news and the screaming headlines that accompany it – Dow Plunges! Exports Collapse! Deflation Looms! – just feed into the uncertainty. Clearly, we must also co-opt the media to turn around confidence more quickly. Perhaps the IMF could do the world a service by setting up a unit to gather and disseminate to the media whatever tidbits of worldwide good news are available. Denial of some realities got us where we are, and perhaps that’s what will help get us out of this hole as well.