The US recovery remains slow by historical standards – even if recent signs of improvement are borne out. One reason is that our unsound fiscal trajectory undermines business confidence, and thus job creation, by creating uncertainty about future policy and exacerbating concerns about the will of Congress to govern. Business leaders frequently cite our fiscal outlook as a deterrent to hiring and investment.
A sound fiscal trajectory is also a prerequisite for interest rates conducive to growth. Continued unsound fiscal conditions will almost surely destabilise markets at some future point. Recent reductions in deficit projections do not change the basic structural picture – except that healthcare cost increases are slowing – and are partly based on sequestration, a terrible policy that already looks too onerous to stick.
In the eurozone, the threat is more immediate. Bond markets in troubled countries were in dire conditions until the European Central Bank’s famous – and as yet unimplemented – 2012 promise to do “whatever it takes”. But ECB actions will not address fiscal and structural issues critical to healthy recovery. Also, the ECB cannot buy sovereign debt indefinitely without triggering capital flight from corporate and sovereign debt markets and the currency. The ECB has bought time, but if that time is not used for policy reforms that win market confidence, bond markets will eventually destabilise.
Unconventional policy decisions by central banks are sometimes justified as the only available tools in the absence of necessary government policies. The right criterion for action, however, is not the absence of alternatives, but an assessment of costs and benefits. In the US, the Federal Reserve’s first programme of quantitative easing was a courageous response to the crisis. And in the eurozone, too, it was imperative to stem the crisis. But the key policy issues have always rested with political leaders.
In the US, there are widely posed questions about the benefits of QE3, but the risks are significant. One is that central bank action will reduce market pressure on political leaders to act. Another is financial moral hazard, where that same comfort may increase reaching for yield in riskier asset classes. The greatest risks of all surround exit strategy.
Unwinding the vast enlargement of the Fed’s balance sheet and liquidity greatly increases the usual risks in monetary policy aimed at price stability, growth and employment. Greater uncertainty means navigating uncharted waters, with heightened chances that tightening leads to a significant downturn. Some suggest that raising interest rates on banks’ excess reserves at the Fed, instead of selling bonds, could limit the risks. But there are no magic wands. No one can reliably project the rate increases needed or the likelihood of destabilising reactions among lenders and borrowers.
Yet waiting too long to tighten heightens the risk of inflation at some point. The Fed’s dramatic expansion of bank reserves could feed excessive credit growth. Along with the possible erosion of Fed credibility on inflation, that could also feed inflationary expectations.
Whether or not QE3 was wise to begin with, the question is what to do now. So-called “tapering” will not withdraw liquidity. Time will tell whether tapering – now under way on a small scale – will increase market interest rates, or whether tapering is already priced in. (Recent rate increases may also reflect improved economic data.) Continued purchasing reduces the risk of market reaction, but increases future unwinding risk. Confidence generated by a sound fiscal regime could help ameliorate both risks.
Such a regime should be enacted now to stabilise, or preferably reduce, the ratio of debt-to-gross domestic product over 10 years, and protect discretionary spending. Implementation, designed in ways difficult to undo, should be deferred for a limited period to allow for recovery. Fiscal discipline could provide room for reasonable stimulus to create jobs. The partially cancelled sequestration should be fully rescinded to eliminate its fiscal drag. Fiscal funding should come largely from revenue increases and beginning the entitlement reforms necessary for long-term sustainability – as President Barack Obama has proposed.
Structural deficit reduction would address growing deficits in the decades beyond the next 10 years. The eurozone, too, should reject false choices. Instead, it should strike the right balance between fiscal discipline to win market and business confidence, and macroeconomic room for growth.
Unconventional monetary policy and stimulus can be part of a successful economic programme for a period of time. But they are no substitute for fiscal discipline, public investment and structural reform.
Robert Rubin is a former US Treasury secretaryFonte: FT
