It’s Too Early to Be Optimistic About the Crisis
Since the spring of 2009, the idea that the worst of the crisis is behind us has gained currency. Timidly at first, then with stronger conviction, economic decision-makers in major countries have started talking about "green shoots of recovery". There has been a stock market rally, with 20-40% increases with respect to early March lows.
Everything is going for the better, then? There are at least three reasons why we should be cautious. The first is that the macroeconomic and financial imbalances that have led to the crisis have not yet been solved, so that the optimism stems from the slowdown in the decline of major indicators (industrial production, especially), rather than from the actual inversion of the recessionary trend. As Fed chief Ben Bernanke said in Congress hearings in early June, "businesses remain very cautious and continue to reduce their workforces and capital investments". Thus, the very real risks of an output gap and a consequent drop in long-term growth loom. Such is the specter of the "Japanese syndrome", where the financial crisis has negatively affected economic growth for over a decade, a burden that is yet to be fully removed.
The conservative economist John Taylor, at Stanford, is worried that "the federal debt is exploding" (Financial Times, May 26): from 48% of GPD, it is projected to jump to 82% in ten years, and to 100% in fifteen, according to the Congressional Budget Office. Managing this mass of additional debt (created to cure excessive private debt) will be extremely difficult, and markets have bet on a significant increase of long-term interest rates.
To this must be added the fact that central banks such as the Fed and the Bank of England are pursuing strategies of quantitative easing and buying long-term government bonds in huge quantities. Taylor argues that today central banks are tempted to induce a hike in inflation to bring public and private debt to sustainable levels. This would arguably be as worrisome as the Japanese scenario. Bernanke's testimony contains implicit references to the fact that, having staved off the danger of deflation and implosion of the world financial system, central banks might have soon to deal with ballooning public debt and inflation. In Europe, the Maastricht Treaty and the ECB's statutes contain an additional defense line against inflation with respect to the US and UK, but Angela Merkel's recent attack against Frankfurt undermines the independence of our central bank for the near future.
Thirdly and lastly, optimism leads to complacency about changing the rules of the financial system. There is the dangerous tendency of considering the financial crisis a temporary accident, and cries are mounting against the excessive cost of more regulation. Even more worrisome, discord is growing on how to globally coordinate national regulators, and even within the eurozone, there is no agreement on how to achieve pan-European financial supervision.
Summing up, the only thing that's certain is that the financial crisis has been brought under control. But three major crisis fronts have yet to be dealt with. It's not time to cheer just yet.