Central banks seek to stabilize financial markets as share values around the world fall sharply and display considerable volatility because of concerns about government finances unlike in 2008 when the worries were about the health of private financial institutions.
The deterioration in public finances has resulted from governments lending to financial institutions to prevent their collapse and expenditures to bolster aggregate demand to prevent economies from slipping into depression.
The policy measures shored up the financial institutions and stemmed the collapse in confidence and economic activity. An economic recovery, albeit weak, began. A weak economy implies low revenues and high expenditures on social safety nets which further raised the deficit. Raising taxes or cutting expenditures will lower GDP and so is unlikely to lower the deficit and the debt-GDP ratio.
In the current circumstances effectiveness of monetary policy in reviving the economy is limited. Central banks conduct monetary policy by buying certain assets and this has a liquidity effect and a lending effect. The central bank, by buying assets from financial institutions, provides these financial institutions with the money they need, the liquidity effect.
The central bank hopes the improved liquidity of these assets will improve their attractiveness so that other financial institutions will be encouraged to buy these assets, particularly buy new issues of these assets, which is tantamount to lending to entities issuing these assets, the lending effect.
Interventions by central banks since 2008 have met the liquidity needs of financial institutions and generally stemmed the fears of these going bankrupt. But despite having large amounts of money banks currently are not willing to lend as repayments remain uncertain because of the weak economy.
Interest rates cannot be lowered further as they are already close to zero. So central banks have acted to widen the class of assets they are willing to buy. They could further enlarge the class of assets they would buy.
But financial institutions may just continue to hoard money and not lend so economic activity would not pick up. There is not much central banks can do to resolve this problem and are therefore unable to raise the level of economic activity by monetary policy.
On the other hand, policymakers face a dilemma if they try to use fiscal policy. Governments in the developed countries have been cutting expenditures or raising taxes immediately to reduce the deficit and the debt-GDP ratio, and raise investor confidence. But cutting expenditures or raising taxes would lower the GDP which may worsen the deficit.
Obviously the debt-GDP ratio will rise if the deficit worsens. But even if the deficit falls, the lower GDP would tend to raise the debt-GDP ratio. It is not easy to devise a fiscal policy that successfully cuts deficits and the debt-GDP ratio.
This can only be done in the long run by letting GDP grow faster. In the past countries have done this by raising exports which will be difficult currently as many countries are cutting expenditures which lowers GDP and import demand.
To make fiscal policy work when monetary policy is ineffective and investors fear high deficits and rising debt-GDP ratios requires coordination both between treasuries and central banks and across countries.
Coordination between treasuries and central banks is needed to prevent a negative reaction from financial markets to increased fiscal stimulus. Coordination among countries would help to prevent a negative reaction as markets could not play off one country against another.
Even if the rate of inflation in developed economies rises because of expansionary fiscal policy, though that is not certain, this might be worthwhile in the current circumstances.
However, many emerging economies such as Brazil, China and India are already suffering from high rates of inflation. While the developed countries could undertake fiscal expansion, coordinating only among themselves, it would be better if there was a consensus with emerging economies and this could be built in the G20.
The emerging economies would need to weigh the relative risks of further slowdown of the developed economies and a higher rate of inflation. Central banks need to coordinate their actions in order to limit currency fluctuations which would add to the existing volatility of stock markets.
Governments need to draw up different scenarios of the paths of GDP, fiscal expenditures and revenues, deficits and debts in different circumstances to show markets that their fiscal policies are viable in the longer run, and this will build the confidence of markets.
Markets would gain confidence through a coordinated response from treasuries and central banks and across countries together with the drawing up of different scenarios based on alternative assumptions so that the short- and long-term issues are seen to be tackled.
Manmohan Agarwal is a senior visiting fellow at the Center for International Governance Innovation, Waterloo, Canada.