Exit Strategies

What’s at stake: As the policy debate switched from crisis response to presaging a return to normal conditions, talks about exit strategies have flourished as most countries have pursued massive financial, monetary and fiscal support policies during the last two years, and there will soon be a need to turn them back. Although the issue did not feature to a great extent at the Pittsburgh summit, it is bound to come back at the forefront of the policy agenda in the near future, potentially as early as next week-end for the Annual Meetings of the IMF and the WB in Turkey.

Paul De Grauwe says that the empirical research used to argue that demand spillovers from fiscal policy are sufficiently small that uncoordinated exits from fiscal stimulus are unlikely to threaten global demand is flawed. It is flawed as it was based on data and theory for economies near full employment – not today’s situation. When one country starts a policy of fiscal contraction this will reduce economic activity domestically – and also negatively affect economic activity in the other countries. In this case, part of the cost of the policy of fiscal restriction spills over to other countries, while the benefit of the restrictive policy (which is the reduction of the budget deficit) is enjoyed by the first country only. The risk of a non-coordinated exit strategy therefore is that it will lead to self-defeating attempts at reducing national budget deficits. Jim O’Neall makes the case against a co-ordinated exit strategy as the crisis is highly asymmetric and requires tailor-made policy responses.

Martin Feldstein says that it would be wrong to have too much faith in G-20’s promises to rein in monetary and fiscal policies, much less to do so in a coordinated way. To reverse the explosive monetary and fiscal expansion of the past two years, to do it neither too soon nor too late, and to do it in a coordinated way are the right things to promise. But looking at it more closely, these promises look pretty empty. Take the G-20’s promise to reduce monetary and fiscal excesses in an internationally coordinated way. While the meaning of “coordinated” has not been spelled out, it presumably implies that the national exit strategies should not lead to significant changes in exchange rates that would upset existing patterns of trade. In fact, however, exchange rates will change – and need to change in order to shrink the existing trade imbalances.

The IMF Global Financial Stability Report says that governments planning to withdraw financial-market support should first exit programs that guarantee bank liabilities and coordinate their moves with other countries to keep a level playing field. Bank-debt guarantees are potentially costly for public finances as governments assume credit risk. Extending such measures in some countries while unwinding them in others could favour some banks at the expense of others, disrupting capital flows. Priority should be given to exiting from support programs that have a significant distortionary impact on financial markets and involve large contingent liabilities for the government. Still, the timing and modalities of these decisions would need to be balanced against the condition of financial markets and, specifically, how illiquid or fragile they may still be.

Adam Posen says that the G-20 discussion has largely ignored the complexities of sequencing and the need for coordination of the policy exists. With respect to sequencing, credible commitments to medium-term fiscal consolidation should precede monetary tightening to pre-empt Volcker-Reagan policy mismatches, which drive up interest rates. The desired structure of the banking system has to be decided before tax policies are changed, since it plays a key role in revenue creation — but actual bank privatization must wait until tax policies are clearly set, or else you end up driving away buyers. Other issues – namely whether withdrawal of current extraordinary liquidity and deposit guarantees would accelerate or offset monetary tightening – will need intensive consultation and study to clarify.

Lorenzo Bini-Smaghi  says that policy tightening cannot wait until inflation materialises, but will have to precede it. He also suggests that monetary stimulus might be withdrawn before fiscal stimulus in the eurozone. The more delayed the fiscal exit, the more the monetary policy exit might have to be brought forward. Indeed, given the level of the debt accumulated in most advanced economies, any delay in the fiscal exit is likely to have an effect on inflation expectations, and may even dis-anchor them. This is a risk that monetary policy cannot take, as it would undermine its overall strategy.

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