The fine line between too much inflation and a W-shaped recession

May 28, 2009

David Riley, the head of sovereign ratings at Fitch, gave the first big presentation at the Fitch banking conference today — and quite rightly, too. The future of banking is inextricable from public finance and macroeconomics: looking at things on a bank-by-bank level ensures that you’ll miss the big picture. His presentation was a good one, and definitely worth blogging.

Riley’s message was simple, after a recap of what happened in the Great Depression and in Japan and in Sweden: the faster that governments move the better, and the stronger their initial response the better. Don’t worry, at least in the short term, about inflation, in an environment such as this one which is fundamentally disinflationary: instead, worry about a multi-year decline in the total quantity of bank credit, which will continue even after the recession has ended, and which will put a medium-term cap on future growth.

Riley was not impressed, in hindsight, with the ad hoc way in which policymakers first addressed the crisis, before Lehman’s collapse: the way they tried to put out fires at places like the monolines or Northern Rock or Bear Stearns, without really tackling the problems of the financial sector more generally.

After Lehman, however, there was much more system-wide intervention, with deposit guarantees being raised, the Fed injecting huge amounts of liquidity into the banking system and the economy as a whole, and the Treasury playing along too with TARP and all the rest. Post-Lehman, said Riley, the international policy response “has been pretty impressive, and well coordinated across countries”.

Interestingly, Riley noted that European households are much more reliant on bank financing than US households are: historically about 80% of their financing comes from the banking sector, compared to about 30% in the US. That probably explains why the Fed has been doing so much in the capital markets (and why the government needed to nationalize Fannie and Freddie), while the ECB hasn’t bothered. But Riley’s charts also showed that Europe is continuing to borrow — at lower rates than in the past, to be sure, but still significant sums — while the US household sector is actually paying down its debts these days, for the first time in living memory.

Riley said he’s not worried about inflation just yet, but that he will be worried about inflation if the government waits too long before unwinding its current fiscal stimulus efforts. On the other hand, it can’t do that too soon, either.

“I think that there is a serious risk that we get a W-shaped recession”, he said, with the current fiscal stimulus running its course over the next year and the economy falling back into recession. “As we saw in Japan,” he said, “if you tighten policy too soon, if you leave it too late, then you start getting concerns about solvency and inflation risk.” Guess he’s happy he’s not a central banker these days.

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