Is the World Ready For the Next Downturn?


In a provocative interview, former U.S. Treasury Secretary Larry Summers recently warned that developed world policymakers are ill-prepared for the next recession. He suggested that the current preoccupation with the avoidance of inflation is a mistake--"inflation is no longer the top issue." The top issue is maintenance of sound growth and getting to full employment.

Summers suggested that the expectation that interest rates will return to their historically normal levels before the next downturn is unlikely: "Downturns happen... when they happen, the normal playbook is to cut interest rates by 500 basis points, but there's not going to be that kind of room."

Is Summers correct that the industrialized world is unprepared? Or do the central banks have a range of tools beyond interest rates that can allow them to meet their inflation targets even during a recession? Then again, how much credibility is there to the chosen 2 percent inflation target? Over the last 600 years, global inflation has averaged 1 percent, with interest rates around 5 percent. Who chose today's 2 percent target rate--and why is it relevant?


Former President, European Central Bank, Chairman of the Board, Bruegel Institute, Chairman, Trilateral Commission for Europe, and Honorary Chairman, Group of Thirty

In case the next downturn is around the corner, the global economy would be placed in an extremely difficult situation for three reasons.

First, in most economies--especially in advanced economies--the fiscal situation is already very difficult. The overall public debt outstanding as a proportion of GDP is significantly augmented in comparison with the pre-crisis level. As a consequence, the room for manoeuvre to counter the recession with fiscal policy would be practically non-existent in an overwhelming majority of advanced economies.

Second, in many economies and more particularly in advanced economies, the monetary policy tools to be utilized in case of a recession would be very limited. Even in the United States, further along in the normalization of monetary policy, interest rates are too low to effectively counter a recession. What is true in the United States is truer for most other advanced economies. And what is obvious in terms of interest rates is also true as regards many of the unconventional tools. The level of central banks' balance sheet portfolios of previous purchases is already very elevated, and the unconventional monetary policy weaponry still utilized suggests that the law of diminishing returns will considerably weaken the central banks' possible action.

Third, perhaps even more importantly, the successive crises which characterized the years 2007/2008/2010 were due to structural defects. With the benefit of hindsight, it is difficult to understand the pre-crisis blindness of most advanced economies vis-a-vis the persistent piling up of additional public and private debt outstanding and the generalized naive belief in the financial market efficiency hypothesis. Also missed were the emerging new systemic risks associated with generalized financial interconnectedness and the surge of information technologies. Among these emerging risks was the formidable rapidity of the crisis contagion process within integrated global finance.

Does the international community understand now the urgent need to reinforce its defenses in anticipation of the next recession whenever it happens? No, as is demonstrated by a striking example: the persistent augmentation of global public and private financial leverage, year after year, since the crisis.

To conclude, my main recommendations to reinforce resilience would be the following:

* Substitute as much as possible equity to debt;

* Remember Irving Fisher and his debt deflation theory;

* Remember Hyman Minsky and his financial instability hypothesis;

* Remember Frank Knight and unquantifiable uncertainty;

* For central banks of the advanced economies: stick to your present definition of price stability, namely 2 percent in the medium and long run.

It is not by chance that major central banks have had the same definition (2 percent) of price stability since the crisis. In periods of high turbulence and high risk, major central banks decided to anchor medium- and long-term expectations as solidly as possible. The recommendations to abandon the 2 percent definition, or retain a higher or lower goal, ignore the importance of solidly anchoring expectations in the longer term.

Let us not now demolish the lessons drawn pragmatically by central banks in a highly turbulent period, namely a degree of rapprochement, which I called "conceptual convergence," of which the same 2 percent definition for medium- and long-term price stability (decided by the European Central Bank at its inception, by the Bank of England in 2003, by the U.S. Federal Reserve in 2012, and by the Bank of Japan in 2013) is a major component!


CIO and Founder, Key Square Capital Management

It is undoubtedly true that developed world policymakers will have a more limited toolbox when the next recession comes, but central bankers will also have had real-time experience evaluating the efficacy of nonstandard policies. However, the scope for easing policy across fiscal and monetary space differs between the major developed economies. This will have important implications for divergent economic performance and asset prices when a downturn arrives.

At the end of 2007, ten-year government bond yields were 4.0 percent, 4.3 percent, and 1.5 percent in the United States, Germany, and Japan, respectively. Today, ten-year government bond yields are near zero in Germany and Japan, and front-end interest rates are negative.

Further, additional European Central Bank bond purchases are effectively constrained by the 33 percent issuer limit, and the Bank of Japan appears increasingly concerned by the risks to financial stability from its ultra-accommodative stance. Indeed, even though Japanese trend inflation is well below the 2 percent target, the central bank may consider adjusting the yield curve upwards in the near future, reflecting Governor Kuroda's concerns over the "reversal rate."

In sum, when the next recession comes, the European Central Bank and the Bank of Japan will both have an extremely limited ability to react.

In contrast, while U.S. interest rates may peak at a lower level this cycle, Larry Summers may be too quick to dismiss the Fed's ability to react to the next downturn, and the effectiveness of the unconventional monetary policy tools that remain. In his June remarks at the Hutchins Center conference, he argues:

Treasuries, imagine that the economy goes into recession and that the Fed cuts short-term rates four or five times, bringing the Federal funds rate to 0.25 percent. If nobody does anything else, the ten-year rate will find its way down to the neighborhood of 1.5 percent. It is questionable how much extra stimulus would be developed by any further reduction in long-term rates below 1.5 percentage points. And that applies with respect to any monetary tool that might be developed. In the previous cycle, from December 2001 to November 2007, the ten-year U.S. Treasury yield averaged 4.4 percent. In the current cycle from July 2009 to present, the ten-year Treasury yield has averaged 2.4 percent, a reduction of approximately 200 basis points. It is unclear why a further 200 basis point reduction to 0.4 percent would not prove equally stimulating. And with the yield curve control tool currently employed by the Bank of Japan, such a reduction in U.S. interest rates is certainly possible. Indeed, the Fed itself engaged in yield curve caps from 1942-1951. While the Fed's blunt instrument of dropping overnight rates might be more limited than before, it is far from out of bullets.


Professor of the Practice of Economic Policy, Harvard University's Kennedy School, Non-Resident Senior Fellow, Peterson Institute for International Economics, and former Chairman, President's Council of Economic Advisers

The United States and other advanced economies are likely to have less monetary space to fight the next recession. The flip side of this fact, however, is that we are likely to have more fiscal space to fight the next recession. The bigger concern is whether we will have the political will to use the tools we have.

The evidence is increasingly strong that equilibrium interest rates have come down throughout the world. The real ten-year rate on government bonds fell by more than 200 basis points in the major advanced economies...

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