A Crisis of Stag-Deflation

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The latest macroeconomic news from the United States, other advanced economies and emerging markets confirm that the global economy will face a severe recession in 2009. In the United States, the recession started in December 2007, and it will last at least until December 2009 -- the longest and deepest U.S. recession since World War II. By the time it is over, the cumulative fall in gross domestic product could easily exceed 5 percent.

The recession in other advanced economies -- Australia, Canada, the European Union, Japan and New Zealand -- started in the second quarter of 2008, which was before the financial turmoil in September and October further aggravated the global credit crunch. This contraction has become even more severe since then.

There is now also the beginning of a hard landing in emerging markets, as the recession in advanced economies, falling commodity prices and capital flight take their toll on growth. Indeed, the world should expect a near recession in Russia and Brazil in 2009 as a result of low commodity prices and a sharp slowdown in China and India.

Other emerging markets in Asia, Africa, Latin America and Europe will not fare better. Indeed, more than a dozen emerging-market economies now face severe financial pressures: Belarus, Bulgaria, Estonia, Hungary, Latvia, Lithuania, Romania, Turkey and Ukraine in Europe; Indonesia and Pakistan in Asia; and Argentina, Ecuador and Venezuela in Latin America. Most of these economies can avoid the worst if they implement the appropriate policy adjustments and the international financial institutions, including the International Monetary Fund, provide enough lending to cover their external financing needs.

With a global recession and fall in aggregate demand a near certainty, deflation -- rather than inflation -- will become the main concern for policy-makers. Rising unemployment rates will cap wage and labor costs, and further falls in commodity prices -- already down 30 percent from their summer peaks -- will only add to these deflationary pressures.

Policy-makers will have to worry about a strange beast called "stag-deflation" -- a recessionary combination of economic stagnation and deflation. They will also have to handle liquidity traps, when official interest rates become so close to zero that traditional monetary policy loses effectiveness. Third, they will confront debt deflation, the rise in the real value of nominal debts, which will increase the risk of bankruptcy for distressed households, firms, financial institutions and governments.

With traditional monetary policy becoming less effective, nontraditional policy tools aimed at generating greater liquidity and credit will become necessary. And while traditional fiscal policy -- government spending and tax cuts -- will be pursued aggressively, nontraditional fiscal policy -- expenditures to bail out financial institutions, lenders and borrowers -- will also become increasingly important.

In the process, the role of states and governments in economic activity will be vastly expanded. Traditionally, central banks have been the lenders of last resort, but now they are becoming the lenders of first and only resort. As banks curtail lending to each other, to other financial institutions and to the corporate sector, central banks are becoming the only lenders around.

Likewise, with household consumption and business investment collapsing, governments will soon become the spenders of first and only resort, stimulating demand and rescuing banks, firms and households. The long-term consequences of the resulting surge in fiscal deficits are serious. If the deficits are monetized by central banks, inflation will follow the short-term deflationary pressures. If they are financed by debt, the long-term solvency of some governments may be at stake unless medium-term fiscal discipline is restored.

Nevertheless, in the short run, very aggressive monetary and fiscal policy actions -- both traditional and nontraditional -- must be undertaken to ensure that the inevitable stag-deflation of 2009 does not persist into 2010 and beyond. So far, the U.S. response appears to be more aggressive than that of the euro zone, as the European Central Bank falls behind the curve on interest rates and the EU's fiscal stance remains weak.

Given the severity of this economic and financial crisis, markets will not mend for a while. The downside risks to the prices of a wide variety of risky assets will remain until there are true signs -- towards the end of 2009 -- that the global economy may recover in 2010.

Nouriel Roubini is professor of economics at the Stern School of Business, New York University, and chairman of RGE Monitor, an economic consultancy. © Project Syndicate