The world economy has seen the greatest fiscal stimulus in peacetime. In the past 18 months governments have pumped cash into their economies to fight recession. Central banks have slashed interest rates and supplemented ultra-cheap money with a policy of quantitative easing (QE). Finance ministries have cut taxes and boosted public spending.
However, economic growth is still heavily dependent on government stimulants, even as their side-effects are becoming clear. In China, a huge, state-directed lending binge has propped up demand but is also fuelling asset bubbles, especially in property. As big, rich economies’ budget deficits have risen more than fourfold, to an average of 9% of GDP, public debt has started to shoot up. In the euro zone, in particular, investors are getting nervous. The recent leap in Greek bond yields and the pressure on Portugal and Spain suggests that some governments may soon run out of fiscal room.
All this leaves policymakers with an unenviable task: deciding when and how to withdraw fiscal injctions. Policymakers have to avoid doing too much too soon, which could kill a frail recovery, and doing too little too late, which could lead to budgetary crises and inflation. A month ago China raised banks’ reserve requirements and began to clamp down on lending. India’s central bank followed suit, Fiscal policy is also being tightened. Brazil India and Mexico all plan to cut their deficits this year.The task is harder in big, rich economies, where growth is more fragile. On February 4th the Bank of England said it was halting its purchases of gilts, but in the United States, Ben Bernanke, its chairma of the Federal Reserve, made it clear that itwas not about to tighten fiscal policy. The IMF, which believes that a “premature and incoherent” exit from stimulus is a serious danger for the world economy, wants no fiscal or monetary tightening in big, rich economies until 2011. Eventually, however, all big, rich economies will have to cut their deficits and keep doing so for several years. Countries that decide to live with higher debt burdens will, in the long run, grow more slowly than the prudent, as government debt crowds out private investment.
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The article Be Afraid, from Economist provides an overview of the challenges facing policy makers dealing with growing public debt an economic slow down. Key terms that students have learnt in Macroeconomics are used by the author and provide an excellent opportunity for students to identify and define these terms and to supply a diagram is relevant.
