Unwinding the monetary and fiscal stimulus

<p><em>Romesh Vaitilingam interviews Pablo Guidotti for Vox</em></p>
<p><em>January 2010</em></p>
<p><em>Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/4462</em></p>
<p><strong>Romesh Vaitilingam</strong>: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Pablo Guidotti, director of the School of Government and Professor of Economics at the Universidad Torcuato Di Tella in Argentin</p>
<p>Pablo and I met at the Global Economic Symposium in Schleswig-Holstein in September 2009, where he was speaking at a session on exit strategies from the financial crisis. I began by asking his view on how to start unwinding the extraordinary monetary and fiscal stimulus measures that policy makers have implemented.</p>
<p><strong>Pablo Guidotti</strong>: The first thing to say is that it's good news that we are talking about the exit strategy. This implies that actually the economy is, in a certain sense, recovering, or at least the prospects are much better than a few months ago.</p>
<p>Certainly the exit strategy reflects the worries about what are the consequences of unprecedented policy actions, both in the monetary side as well as in the fiscal side. And also, some additional actions that have been taken directly as direct intervention in the banking system, such as the insurance provided, such as guarantees on debt issues, injections of capital, and so on.</p>
<p>In terms of, of course, the monetary aspects, there are two main questions. First of all, how to unwind the dramatic expansion in central banks' balance sheets, and second, what to do with all the troubled assets that central banks, and particularly the Fed, has acquired in the process of intervention.</p>
<p>And with respect to the fiscal side, there are two main questions. First of all, the extent to which fiscal stimulus actually has been effective, and what are the risks into the future in terms of debt sustainability. Let me give you sort of a one-liner, in the way in which I see these risks in this area.</p>
<p>My impression is that monetary policy actions have been effective and that the unwinding poses relatively few risks into the future. Risks, as regards fiscal policy, my impression is that the role of fiscal stimulus has been overestimated, and that the risks to debt sustainability are important.</p>
<p><strong>Romesh</strong>: OK, let's take those two issues separately, if we could. First of all, focusing on the issue of inflation versus deflation. Part of the monetary policy easing has been because of a really serious fear of deflation, perhaps overplayed, I'd be interested on your view on that. How do you think that things are playing out in terms of the anxieties about deflation, and now, fears about inflation?</p>
<p><strong>Pablo</strong>: You know, my general impression is that the central bank, the conduct of monetary policy has been appropriate, in terms of effectively avoiding deflation, and at the same time, responding quite adequately to the disruptions in the financial markets, and in the banking system.</p>
<p>Of course in this process, the expansion of the balance sheets that, for instance in the case of the Fed, has moved to a level of $800 billion to over $2 trillion in this period, of course reflects an increase in excess reserves that banks have at the central bank.</p>
<p>The question is, what happens when these excess reserves are reduced? My impression is that central banks have essentially all the instruments to actually deal with this unwinding without major risks to inflation. In terms of instruments to be used, on the one hand you have traditional instruments such as open market operations with government securities, you have reverse repos&hellip; Now for instance, as in the case of the Fed, the Fed can pay interest on reserves. Of course that entails some cost.</p>
<p>The only thing that I would add, that maybe one could consider some levels of reserve requirements used transitorily, and then maybe paying interest on the excess reserves over those reserve requirements that could actually limit the cost and improve the control of the central bank on the monetary base. Then you have other lines, liquidities, facilities, provided to banks that actually have automatic mechanisms for the unwinding.</p>
<p>I think that the challenges on the monetary, for the central bank, are probably mostly an issue of priorities. So, deal with the monetary issues specifically with traditional monetary instruments. And I would put at a much slower pace the issue of reducing or dealing with the troubled assets that the central bank has acquired.</p>
<p>This is because, first of all, selling these assets, for instance in this context, could actually undermine some of the improvement in these markets. At the same time, given that the valuations are not clearly stabilized, it could result in undue losses for the central banks. So I would say that that is a longer process.</p>
<p><strong>Romesh</strong>: Let's talk a little bit about the fiscal side, because the issue here is with the huge fiscal stimulus that has gone in, whether public debt is going to be sustainable in the future, and what the implications are in terms of fiscal policy within countries, but then also the temptation, perhaps, for many governments to inflate away their debt.</p>
<p><strong>Pablo</strong>: Exactly. When in fact, as I was saying, I don't see inflation risk from the monetary policies side. I think the risks of seeing higher inflation come actually more from the fiscal side. What we are seeing here, just using the very recent projections that the IMF has put out on the debt ratios for the advanced economies, we are looking at a situation in which both from the automatic stabilizers as well as the stimulus packages implemented, we have a debt ratio for the advanced economies within the G20 rising over the medium term to about 120% of GDP by the year 2014, with levels of deficits close to 10% and in some cases, well above 10% of the GDP such as the case of the US.</p>
<p>And this imposes of course a significant fiscal adjustment to make these high levels sustainable. My impression is that the type of projections that have been put out are actually optimistic.</p>
<p>There are actually two things, two different things. First of all, as I was saying earlier, I think that the role of fiscal stimulus has been overdone. If one looks at the experiences from recoveries of crises in emerging market economies, where clearly governments do not have the ability of providing fiscal stimulus, one can see that after financial crises, the recoveries are relatively fast, even though the quality of the recovery is not very good in the sense that credit is slow to recover, and that investment remains low, and so on.</p>
<p>When you look at the type of recovery that we are seeing today in the advanced economies, it also doesn't seem to be a very good quality. So it's not clear, I think that the jury is still out as to the effectiveness of fiscal stimulus.</p>
<p>And when you put this issue into the medium term dimension of fiscal sustainability, then I would say that the recommendation that I would make is that fiscal stimulus should be undone much sooner than later. And certainly I would refrain from adding more fiscal stimulus, as some are suggesting, to the recovery.</p>
<p>Now in terms of the medium term, I think that there are a couple of things that have to be mentioned. First of all, as I was saying, the projections of the IMF, in my view, are optimistic. They are based on an assumption that eventually the resumption of growth goes back to previous levels and that interest rates remain low.</p>
<p>Now, an interesting thing that the IMF has also studied, is do you recover in terms of growth? And the result of that study shows that in fact you don't recover potential output. So you end up after the crisis with a gap in potential output of close to 10%, which implies that if you take the net present value of this, you have a major wealth effect which is of a permanent nature.</p>
<p>And this makes me think that, in fact, consumption will not recover very quickly because in addition many of the advanced economies - and especially in the case of the US - still display a significant current account deficit. So eventually I think these are issues that make you think that growth will be slow.</p>
<p>The second thing is that once you start to see many countries with debt-to-GDP levels very high, then the question is will there be a role for inflation? And the question is not so much that authorities, governments, will actually pursue it actively but what happens if markets or bondholders start to think that eventually inflation will be part of the solution?</p>
<p>In that case you get clearly, very easily, you can get an increase an interest rates of two, three points, percent of GDP. In that case, all the scenarios change dramatically for the worse.</p>
<p>In addition I am skeptical about these scenarios because they extrapolate a future that has no accidents. And what often happens is that you may be right for two or three years, but then if something else happens, and takes you off that nice path that you had designed, then suddenly you end up with a problem that is significantly larger than what you anticipated.</p>
<p>Many people in the advanced economies are actually putting out the following argument. They are saying, well, you have to look at the fiscal problem as a more general problem, not simply this increasing that, but you have to look at the health and contingency as the pensions, contingent liabilities, and when you look at that, then the contingent debt is far larger than the actual debt.</p>
<p>I would say that I take that argument with some skepticism. Because, if that argument is used to say that then you don't have to worry about the 120% because you need to worry about the other 400%, I would say that would be a huge mistake.</p>
<p>Because the difference between these two types of debt is that the contingent debt is not translated today into bonds, which actually trade in the market. So I would be worried if one simply argues that the solution is, for instance, to privatize the pension system.</p>
<p>The experience in Latin America is that the transition costs in terms of bond issuance that are needed to actually solve these long-term problems is very significant. And my impression is that in the advanced economies, still most people work under the assumption that governments have infinite access to the capital market.</p>
<p>And I think that the experience is that you don't think you have a problem until you have it. And I think that governments should worry much more about liquidity issues and whether the amount of debt that is going to be piling up in the markets in the coming years from several advanced economies eventually will not produce significant increases in interest rates.</p>
<p><strong>Romesh</strong>: Pablo Guidotti, thank you very much.<br />
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