Beyond Stimulus

In his column “The pain caucus” ( IHTJune 1), Paul Krugman raises questions about the economic outlook of the Organization for Economic Cooperation and Development. He writes that the O.E.C.D. is effectively saying that “policymakers should stop promoting economic recovery and instead begin raising interest rates and slashing spending.”

The global economy is beginning to recover. Emerging markets, especially China and India, are leading the way. World trade, which collapsed at the end of 2008, has bounced back. The United States has now had three quarters of positive growth, and real gross domestic product surely grew in the second quarter of this year as well.

But we are not out of the woods. If history is any guide, the recovery will be relatively weak. Unemployment is very high and it will be some time before it falls to acceptable levels. In the United States, the unemployment rate has peaked and we believe it will gradually fall through 2011 and beyond. Financial markets remain delicate, and recently reacted strongly to perceptions of excessive or rising risk.

This is therefore an unusually difficult time for policymakers. The nascent recovery, though due in part to continued strong growth in emerging economies, also reflects the success of monetary and fiscal stimulus in most O.E.C.D. economies.

As the recovery progresses, this extraordinary stimulus will have to be withdrawn. Otherwise, it will only feed another bubble. But withdrawing the stimulus too abruptly could cut the recovery short. For some time, therefore, policymaking will involve trading off these risks. To a large extent, the issue is one of timing: when and how quickly should policy stimulus be withdrawn?

The balance of risks is shifting. In particular, the risks of running a zero interest rate policy and large budget deficits are rising. Recent events in Europe are a warning sign regarding fiscal deficits and rising public debt.

To manage these risks in our unsettled financial environment, we believe governments have to get out ahead of markets. Otherwise, as some governments have recently discovered, markets can suddenly and sharply narrow the room for policy maneuver.

To be sure, not every country is in the same situation. Time is running out for all, but at different speeds. Some countries, such as Greece, have no real choice but to reduce their deficits now, even though it will hurt. The United States is not in this position. President Obama’s plan to reduce deficits gradually over the next five years is a good trade-off between stemming a potentially dangerous increase in the national debt and preserving the economic recovery.

On monetary policy, the issue is not whether inflation is a risk today — it is not — but whether it will be a problem in two years’ time. The need to be forward-looking means beginning to ease up gradually on monetary stimulus by the end of this year. Effectively, zero interest rates in the euro area, Japan, Britain and the United States are creating distortions in capital markets. Monetary conditions need to be back to normal by the time economic slack disappears and inflationary pressures begin to reassert themselves.

Raising real interest rates above zero would signal a commitment to contain inflation, helping to check inflationary expectations and hold down market interest rates two and three years into the future. If there is more fiscal tightening, on the other hand, interest rates can remain lower for longer. The crucial point is that policy needs to be forward-looking if governments are going to seize the initiative back from financial markets.

To be clear, we do not advocate monetary contraction in the United States. In our view, stimulus should continue until the economy returns to full employment. But staying ahead of the markets requires pre-emptive action to avoid sudden changes in policy later.

In particular, governments should try to avoid being put in a position of having to raise interest rates abruptly at a later stage to keep inflationary expectations under control.

Pier Carlo Padoan, deputy secretary-general and chief economist of the O.E.C.D.