Preparing the exit

The recovery that began earlier this year in a number of non-OECD economies has now spread to the OECD area at large. But in most OECD economies, growth is likely to fluctuate around a modest underlying rate for some time to come. It is being held back by still substantial headwinds as households, financial institutions, non-financial enterprises and, eventually, governments have to repair their balance sheets. This also means that unemployment is set to move higher and already-low inflation will be under further downward pressure. It is only some time down the line that the recovery will become sufficiently strong to begin to reduce unemployment.

The upturn in the major non-OECD countries, especially in Asia and particularly in China, is now a well-established source of strength for the more feeble OECD recovery. The strength of the upturn reflects both the limited direct exposure to the financial origins of the crisis and the strong policy stimulus these countries were in a position to apply. The major policy issue in many of these countries is now becoming one of withdrawal of stimulus so as to avoid igniting asset or general price inflation.

The US economy is recovering on the back of policy stimulus, improving financial conditions, non-OECD demand growth, normalisation of stock-building and stabilisation of the housing market. With rapid labour shedding in the downturn, employment should respond quickly to economic activity and unemployment may peak in the first half of 2010.

The euro area economy will benefit from many of the same growth-drivers as the United States. But work-sharing schemes which cushioned employment in the downturn may also weaken the employment intensity of growth going forward. With unemployment not set to peak before theend of 2010 or the beginning of 2011, household confidence is likely to be weak and sap the strength of the recovery.

Japan is well positioned to benefit from strong growth in the rest of Asia but, fiscal stimulus notwithstanding, weakness on the domestic side will remain a drag on growth. With activity insufficient to materially reduce unemployment, deflation is set to linger.

The risks around the projection are substantial. A main risk on the downside relates to how rapidly consumers will choose to rebuild their balance sheets. The projections mostly embody saving rates remaining stable at their recent higher level, which corresponds to what should be expected based on past behaviour, but households could wish to rebuild their balance sheets more rapidly or be forced to do so by financial constraints. Conversely, the projections also embody an only modest increase in the business investment share of GDP following its recent steep fall and that could be too pessimistic. Moreover, just as the collapse in international trade propagated and intensified the downturn, its rebound may prove faster than expected, which could stimulate economic activity. Financial conditions going either way relative to the assumption behind the projections is another risk.

International imbalances, notably the US deficit and the China surplus, have narrowed appreciably during the downturn. The projections imply that this adjustment has now run its course. With imbalances remaining at levels that would have been unprecedented just a few years ago, the risk of disorderly exchange rate adjustment cannot be excluded. This underlines the importance of international efforts, recently given impetus in the context of G20, to ensure a sustainable international growth pattern.

Overall the risks around the projection may be balanced; but the same may not be the case for their consequences. With inflation being low to begin with and set to fall further in most countries, the fall-out from downside risk could be much worse. Japan’s experience has shown that it is more difficult to exit than to enter deflation and that deflation makes it much harder for policy to respond to adverse shocks.

These are the rather inauspicious conditions under which governments and central banks have to consider when and how rapidly to roll back many of the measures taken in response to the crisis. Yet preparing exit strategies cannot be put off. Many of the interventions, while appropriate during the crisis, would be harmful if they stayed in place for too long. Preparing and communicating well articulated exit strategies will increase confidence that there is a way out. That in itself will allow for greater flexibility in the implementation of the strategy.

Spelling out exit strategies is also useful because many of the policies that will form part of such strategies can be expected to have international spillovers, calling for various degrees of co-ordination across countries ranging from ex ante information sharing to collective policy approaches. Against this background it is regrettable that so few exit strategies have so far been articulated–with, for example, less than half of OECD countries having announced medium-term fiscal consolidation programmes with a clear description of the instruments to achieve the final target.

Conventional monetary policy clearly has to reflect domestic economic circumstances, and some countries with incipient upward pressure on asset and consumer prices have indeed already begun tightening. But, on the projections in this Outlook, for the majority of OECD countries monetary policy will need to move slowly. With inflation clearly below policy objectives, policy interest rates should only be back to neutrality by the time inflationary pressures begin to be felt. The implied constellation of interest rates across countries could result in capital movements and pressure on asset prices in countries that are ahead in the cycle. Similarly, easy monetary conditions in the majority of OECD countries could risk spilling over into unjustified asset price increases. While asset price developments is a factor that needs to be taken into account by monetary policy, in general other instruments are able to influence these prices more directly and effectively.

Unconventional monetary policies have led to a large overhang of liquidity–indeed, their aim was partly to respond to increased liquidity preference and to ensure that the stability of financial institutions would not be threatened by lack of liquidity. As conditions normalise it will be necessary to absorb excess liquidity. This will call for a number of policy initiatives and it is important to spell out the game plan in this area to avoid misinterpretations of central bank actions. Likewise, the removal of funding guarantees and recent extensions of deposit guarantees needs to proceed in a well ordered manner. In the case of certain liquidity measures and guarantees, it maybe better to phase out banks’ use of these schemes by making it sufficiently costly, while keeping the schemes in place for some time to avoid having to reintroduce them in case of renewed instability, which could undermine confidence.

As regards extended deposit insurance, rolling it back may require international co-ordination as few countries may be willing to move ahead alone with a measure that could weaken the competitiveness of domestic banks.

Government budgets have suffered badly from the crisis and gross debt could exceed GDP on average in the OECD by 2011. Stopping the rot is clearly necessary and will call for fiscal consolidation that is substantial in most cases and drastic in some. That said, and countries facing acute pressures aside, consolidation should not proceed at a pace that undermines the recovery. It is worth keeping in mind that with simultaneous fiscal consolidation across countries, activity will be affected not only by domestic consolidation but also, via trade linkages, by consolidation abroad. Also, with policy interest rates in many countries set to remain low for quite some time to come, monetary policy will have little room to accommodate fiscal consolidation. Flexibility in consolidation requires, however, maintaining the confidence of financial markets and of households which again requires credible communication of the commitment to consolidate over time. Early implementation of long overdue reforms to pension and health schemes could help signal such commitment–and such reforms are unlikely to have significant negative demand effects in the short term.

Fiscal consolidation will also need to be undertaken in a manner that does not amplify the effect of the crisis on potential output. That means concentrating on those spending components and sources of taxation that are least likely to undermine growth. At the same time, most structural reforms that boost potential output will also help the process of fiscal consolidation.

It is heartening that the crisis has not been accompanied by widespread government interference in non-financial markets. In particular, protectionist measures and measures aimed at hiding unemployment by permanently removing some potential job-seekers from the labour market have been rare so far. The car industry is an unfortunate exception to the general rule, however. And the measures in favour of short-time working, which have been very helpful in cushioning unemployment in the downturn, also bear monitoring lest short-time working becomes a permanent feature. Indeed, there need to be sufficient disincentives for employers and workers to make use of these schemes during normal times. At the same time, it will be crucial that labour market policies minimise the risk of unemployment becoming structural. In this environment, a particularly important set of structural reforms will be those affecting financial markets. Unwarranted build-ups of leverage, risk-taking and asset prices, as occurred before the crisis, must not be repeated. In this regard, the now officially recognised status of some banks as being too big or too interconnected to fail is an issue that needs to be addressed. Absent action to break up such banks, regulation will need to fully offset the associated incentives for risky behaviour through higher capital buffers, the use of convertible debt, living wills or other means. In turn, such measures will reduce the incentives for banks to reach systemic size. In any case, it is important that the private sector be given clear signals regarding the future regulatory and institutional landscape so that it can begin to adjust towards the new framework within which it has to operate.

Overall, unprecedented policy efforts appear to have succeeded in limiting the severity of the downturn and fostering a recovery to a degree that was largely unexpected even six months ago. It is now time to plan the exit strategy from the crisis policies, even if its implementation will be progressive. Radical policy action will be required in the years to come to restore sound macroeconomic balance, healthy growth and low unemployment. Only when that has happened will the crisis have been fully overcome.

This article is based on the editorial of OECD Economic Outlook No 86, November 2009. The sign-off date was 16 November 2009. Order the full edition at

Jorgen Elmeskov was acting head of the OECD Economics Department at the time of writing and is now deputy chief economist. Pier Carlo Padoan was appointed as OECD chief economist in December.

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