a deadly combination of economic stagnation/recession and deflation.
A severe global recession will lead to deflationary pressures. Falling
demand will lead to lower inflation as companies cut prices to reduce
excess inventory. Slack in labour markets from rising unemployment
will control labour costs and wage growth. Further slack in commodity
markets as prices fall will lead to sharply lower inflation. Thus
inflation in advanced economies will fall towards the 1 per cent level
that leads to concerns about deflation.
Deflation is dangerous as it leads to a liquidity trap, a deflation
trap and a debt deflation trap: nominal policy rates cannot fall below
zero and thus monetary policy becomes ineffective. We are already in
this liquidity trap since the Fed funds target rate is still 1 per
cent but the effective one is close to zero as the Federal Reserve has
flooded the financial system with liquidity; and by early 2009 the
target Fed funds rate will formally hit 0 per cent. Also, in deflation
the fall in prices means the real cost of capital is high ??? despite
policy rates close to zero ??? leading to further falls in consumption
and investment. This fall in demand and prices leads to a vicious
circle: incomes and jobs are cut, leading to further falls in demand
and prices (a deflation trap); and the real value of nominal debts
rises (a debt deflation trap) making debtors’ problems more severe and
leading to a rising risk of corporate and household defaults that will
exacerbate credit losses of financial institutions.
As traditional monetary policy becomes ineffective, other unorthodox
policies have been used: massive provision of liquidity to financial
institutions to unclog the liquidity crunch and reduce the spread
between short-term market rates and policy rates; quasi-fiscal
policies to bail out investors, lenders and borrowers. And even more
unorthodox “crazy” policy actions become necessary to reduce the
rising spread between long-term interest rates on government bonds and
policy rates and the high spread of short-term and long-term market
rates (mortgage rates, commercial paper, consumer credit) relative to
short-term and long-term government bonds.
To reduce the former spread the central bank needs to commit to
maintain policy rates close to zero for a long time and/or start
outright purchases of government bonds; to reduce the latter it needs
to spread massive liquidity, such as by direct purchases of commercial
paper, mortgages, mortgage-backed securities (MBS) and other
asset-backed securities. The Fed has already crossed that bridge with
facilities that are aimed at reducing short-term market rates, such as
Libor spreads; it has now moved to influence long-term mortgage rates
by buying MBSs.
Traditionally, central banks are the lenders of last resort but they
are becoming the lenders of first and only resort, as banks are not
lending. Central banks are becoming the only lenders in the land. With
consumption by households and capital spending by corporations
collapsing, governments will soon become the spenders of first and
only resort as fiscal deficits surge.
The financial crisis has already become global as financial links
transmitted US shocks globally. The overall credit losses are likely
to be close to a staggering $2,000bn. Thus, unless financial
institutions are rapidly recapitalised by governments the credit
crunch will become even more severe as losses mount faster than
But with governments and central banks bringing private sector losses
on to their balance sheets, fiscal deficits will top $1,000bn for the
US in the next two years. The Fed and the Treasury are taking a
massive amount of credit risk, endangering the long-term solvency of
the US government.
In the next few months, the flow of macroeconomic and earnings news
will be much worse than expected. The credit crunch will get worse,
with de??leveraging continuing as hedge funds and other leveraged
players are forced to sell assets into illiquid and distressed
markets, leading to further cascading falls in prices, other insolvent
financial institutions going bust and a few emerging market economies
entering a full-blown financial crisis.
The worst is not behind us: 2009 will be a painful year of a global
recession, deflation and bankruptcies. Only very aggressive and
co-ordinated policy actions will ensure the global economy recovers in
2010 rather than facing protracted stagnation and deflation.