For the last two years (see earlier blogs)we have emphasized that credibility of fiscal policy depends more on legal and procedural reforms that will lead to a steady and sustained reduction in the fiscal deficit over the medium-long term and less on an immediate drastic squeeze on expenditures. Even in the few cases that the latter helps establish credibility about the former, the consequent reduction in growth will inevitably undermine the short term gains and shake the presumed “anchor.” This will inevitably require a moderation of the “excessive squeeze” and undermine any short term gains in credibility. Thus even in the short term it is better to moderate the growth of consumption expenditures and fiscal transfers and to shift expenditures to productivity and growth enhancing investment expenditures.
In deciding on the appropriate fiscal-monetary policy mix, we have to distinguish, first between reserve currency countries,such as USA and others. In the former case, there is a danger that a large part of the monetary expansion will transfer into rise in global commodity and asset prices, rather than enhancing domestic investment. This is further exacerbated in the case of private consumption based on consumer credit as the failure to solve the Household mortgage problem early in the post-crises period, has resulted in a deleveraging process that is much longer and more painful than it could have been with early action.
In other countries, we have to again distinguish between countries constrained by currency union (e.g. EU) and those not so constrained. In currency Union countries, self imposed constraints (EU on ECB) on monetary policy have exacerbated the crises. Monetary policy was much tighter than it should have been. The recent loosening of monetary policy, has gone about half way to correcting the problem. This process needs to be continued if the fear of contagion within the currency Union is to be eliminated. The fiscal situation that matters in this case is the overall fiscal position of the currency Union, which is adequate to allow for a substantial further easing of the monetary policy approach, provided the debt of the insolvent countries is written off and all countries with tenuous fiscal situation make fundamental changes in their expenditure and tax policies to ensure future sustainability.