Credit Crises and the Shortcomings of Traditional Policy Responses

Economic downturns which have their roots in preceding credit excesses and debt overhang have tendedhistorically to be long lasting, whether the financial sector remained healthy or not. There are no good reasonsto believe the current global crisis will be any different. Moreover, it is argued in this paper that the policyresponses to the crisis to date, both macroeconomic and structural, will not succeed in restoring sustainablegrowth. Monetary and fiscal stimulus might raise aggregate demand in the short run, but they contribute tohigher debt levels which are already working increasingly in the opposite direction. Structural policies intendedto maintain pre crisis production patterns, both in the financial and industrial sectors, ignore the unsustainabilityof those structures in the first place.Alternative policies are needed to meet the G 20’s goal of “strong, sustainable and balanced growth”. Theyinclude more international cooperation between creditor and debtor countries (on both exchange rates andproduction structures), more recourse to explicit debt restructuring (for both households and sovereigns), andstructural polices to raise potential growth and make debts more sustainable. Unfortunately, there remainformidable practical and political obstacles to pursuing such policies.Future debt crises of the current magnitude could be avoided by using monetary, macro prudential and fiscalpolicies more symmetrically over the business cycle. Relative to past behaviour, this would imply morevigorous resistance to credit financed upswings, and a greater willingness to accept the cleansing effect of minordownswings. Policies to ensure financial stability are important but secondary.