To the Point
Discussion on the economy, by the Chief Economist
Cecilia Hermansson
Chief Economist
Economic Research Department
+46-8-5859 1588
cecilia.hermansson@swedbank.com
No. 3
2010 03 30
March 30, 2010
The art of doing it right
Our global forecast from March 18th envisaged a slow recovery for the
world economy with diverging developments between industrial countries
and emerging markets. The outlook for China and India is clearly positive
with GDP growth rates of 8-9%, while growth in the US, Europe and Japan
more or less stays between 1 and 2.5%. The somewhat faster upturn in the
US this year is mainly a result of inventory adjustments and stimulus
measures, while underlying demand in most mature economies will remain
weak.
A slow and bumpy recovery may not be problematic as long as a double dip
can be avoided. More important are the many policy challenges facing the
world economy in general, and industrial countries in particular.
Deleveraging in the private sector, consolidating public finances to deal with
sovereign debt, withdrawing monetary policy stimulus, and rebalancing
growth in Europe as well as globally are just a few. In addition, structural
adjustments to counter increasing competition from emerging markets,
climate change, energy renewal, the development of welfare systems and
demographics are issues that must be addressed by policymakers. This
version of To the Point discusses the art of doing it right over the next few
years. We limit the discussion to the following areas:
1. Realistic policy-making
2. Monetary policy and financial regulation
3. Fiscal policy
4. Rebalancing growth
5. Growth policies and structural reforms
Realistic policy-making
With so many challenges facing policymakers at the same time, policies have to be
coordinated at many different levels, such as: 1) between fiscal and monetary
economic policies, 2) between countries and regions, 3) between national political
parties, and 4) over time.
Policymakers have been successful in managing the crisis, but will they also be
successful in preventing new ones? The dilemma they face is that as long as there is a
risk that the recovery will come to a halt, financial regulation should not be altered
nor should austerity measures be put in place, but when the growth outlook has
substantially improved the window of opportunity may have closed. Therefore, the
lessons learnt from the crisis must be kept alive and policies must be coordinated
from a long-term perspective.
There are challenges for politicians in developing policies that may come into practice
many years after they have left the political scene. In addition, most practices are
local or national, even though they are affected by other countries’ policies. Creating
policies on a regional or global level – and with a longer horizon – is much more
demanding for policymakers than usual.
To the Point (continued)
March 30, 2010

Most economic policies announced, for example, in the EU or the US have

incorporated optimistic growth assumptions over the next few years. This may
prove counterproductive if there is no Plan B. Why not be more cautious on growth
assumptions as the crisis in itself may have lowered potential growth and altered
economic models used to calculate growth? This would leave room for more
realistic policies going forward. At a minimum, worst case scenarios should be
created with a Plan B attached.

Monetary policy and financial regulation

Central banks face challenges on many fronts. Balance sheet policies must be
scaled back as the crisis abates, but when government bonds or the housing market
are involved it will be much more difficult to phase out the stimulus. Keeping the
repo rate low for an extended period of time may be good for the real economy, but
the transmission mechanism is not as strong as usual, and instead of supporting
companies there is a risk that household credits grow too fast in countries where
housing markets have been robust during the crisis.
There are tests ahead for central bankers in combining financial stability with price
stability. We could see a situation with lingering problems in the financial sector
and increasing inflation in consumer prices. Most likely, the goal of price stability
will be set aside if financial stability is threatened. There is also a need for more
research on how to combine these goals. So far, dealing with asset prices seems to
have been asymmetric in the sense that interest rates have been lowered (in
Chart 1: Inflation in the OECD countries particular in the US) when asset prices have fallen, but have not increased when
1972-2010
asset prices have risen too fast. Leaning against the wind is one way of taking asset
17.5 prices into consideration, but more research is needed, not least to understand the
15.0
impact of often volatile asset prices on monetary policy.

12.5 Instead of discussing these challenges, there has been unreasonably large focus on
the acceptable level of inflation. IMF Chief Economist Olivier Blanchard may have
10.0
an academic interest when he suggested it would be worthwhile to analyse the pros
Percent

7.5
of raising the level from 2% to 4% so that monetary policy could respond more
5.0 aggressively to economic shocks. For practitioners it must have seemed like a joke.
2.5
At a time of growing uncertainty regarding central banks’ and governments’
commitment to keeping inflation low, it is important to stick to the anchor created.
0.0
It has taken years to develop inflation expectations around 2%, and by altering them
-2.5
72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10
the confidence in central banks and governments may be lost. Besides, while the
Source: Reuters EcoWin level may be raised in theory, in practice it is not possible to increase inflation “just
a bit”. If raised to 4%, why not 6% or 8%? And higher and more volatile real
interest rates would clearly be more of a disadvantage to the economy than an
advantage.
Monetary policy will have to be reformed in the years to come. Inflation targeting
focused solely on consumer prices will have to be complemented with a larger
focus on asset prices, credit growth and financial stability in the longer term. In the
meantime it is important to stick to the inflation targets that have been set up as
policy makers’ commitment to keeping inflation low is being questioned.
While overregulating the financial sector must be avoided, there is still a need for
smarter regulation and supervision. The most important thing is to make the
financial sector less procyclical and more macro prudential. Creating incentives to
reduce the risk of moral hazard is also important, as is creating a financial sector
that can be an intermediary for the capital needed to facilitate growth and structural
transformation. As the financial sector will always be fragile, the right level for
capital requirements is hard to find. Too high of a requirement will raise capital
costs for companies and households, and too low of a requirement could increase
instability in the longer term.

2
To the Point (continued)
March 30, 2010

Fiscal policy
As central banks unwind their balance sheet policies and keep repo rates low,
Chart 2: Fiscal position in selected OECD- governments must deal with rising sovereign debt causing turbulence on financial
countries markets and negatively affecting growth. In countries like Ireland, Greece, Portugal
Public debt, % av GDP
250 and the Baltics, budget consolidation has already begun. In the Baltics especially,
Japan there is an awareness of the need for austerity, but in many other EU countries this
200 awareness is still lacking.
For the US, UK, France and other large economies, there is also a need to create
150
Greece awareness. It will no longer be possible for them to live beyond the means, as it
Italy
100 Portugal
Belgium most likely will become harder to find financing in the future. Because banks may
USA
Ireland UK France Eurozone Germany
also have to raise more capital, the combination of high sovereign debt and tighter
50 Spain financial regulation may increase interest rates going forward.
Finland Sweden
Budget consolidation will most likely start during the next year in most larger
0
economies. Still, there is lack of detail in the austerity plans, and most growth
-16 -14 -12 -10 -8 -6 -4 -2 0
Budget balance,% av GDP assumptions are too optimistic. How to raise taxes and lower expenditures when
voters are not ready can certainly be a challenge. In the EU, there is still a vision of
expanding the welfare state, lowering working hours, and further reducing taxes.
Add the demographic challenge, and the equation will be hard to solve.
After the high inflation of the 1970’s and 80’s, new institutions were set up in many
countries, such as inflation targeting, an independent central bank, etc. Efforts to
create lower inflation expectations were successful, and inflation targeting served
its purpose for many years (but became too narrow-minded when asset bubbles
started to blow up more frequently). Now it is time to strengthen institutions that
create budget discipline in both good times and bad. Sweden is a case in point.
After the financial and property crisis in the early 1990’s, expenditure ceilings and
budget goals were established, improving fiscal discipline since then. The fact that
most EU countries allowed budget deficits during the good times points to the need
for such institutions, including independent fiscal councils and fixed targets.

Rebalancing growth
Germany should not become less competitive, as has been suggested as a solution
to rebalancing growth within the Euro zone. Of course, countries like Greece,
Portugal and Spain must become more competitive. The agenda for 2020 rightly
points to reforms to increase competitiveness in Europe as a whole. As these
countries must improve their external balances, however, there must be increasing
demand from outside of Europe to absorb the larger European export volumes.
Where is this demand going to come from?
Countries with high surpluses today (e.g., China, Japan, Germany, Arab countries,
Singapore, Norway and Sweden) will be the ones best able to absorb most of the
rebalancing of growth. They have more leeway to increase demand among
companies and households. The problem is that it takes time. In China, for example,
the social security system must be developed in order to lower the need for savings,
and that is a slow and complicated process.
The US congress is pressing the Obama administration to declare China a currency
manipulator on April 15th, when a report is due to be presented by the Treasury. If
this happens, the US may take the issue to the World Trade Organisation (WTO) or
start raising tariffs on Chinese products. As China will not succumb to foreign
pressure, there is a risk that declaring China a manipulator will develop into a trade
war. If anything, this would be devastating to global economic growth going
forward.

3
To the Point (continued)
March 30, 2010

China has increased imports during the crisis and become a growth engine in the
world economy, although perhaps not sufficiently so. The rebalancing must
Chart 3: GDP Growth according to continue, as the US and the UK can no longer be consumers of last resort; other
Swedbank’s forecast countries must slowly take over. For Europe to take greater responsibility, the key
12
is to continue with growth-oriented policies and structural reforms that increase
10 2009
2010
domestic demand, for example, by integrating service markets.
8
2011
6
4
2012 Growth policies and structural reforms
2
The best way to reduce sovereign debt in industrial countries is not by increasing
0
inflation. A recent IMF study by Carlo Cottarelli shows that with 6% inflation
-2 (instead of 2%), public debt as a share of GDP would be 8 percentage points lower
-4 in 2014 in the OECD countries. Therefore, inflation would have to be much higher
-6 for several years to have a substantial impact on debt ratios, and then there would
-8 be significant disadvantages for the real economy. Raising taxes and cutting
USA EMU Japan China India Global expenditures considerably could cause anaemic growth for years. So despite the
GDP
need, there also have to be structural reforms and growth-oriented policies that at
the same time enhance growth.
Notwithstanding the stimulus measures used to boost demand, the recovery in the
industrial economies has been less than convincing. Supply side measures must be
added, such as improvements to education and research systems, better rules for
entrepreneurship, and micro-oriented reforms that improve efficiencies in labour
markets, housing markets and product markets. The EU in particular has much to
gain by increasing competition and better integrating the service sector. Further,
climate change could create incentives for investments in green infrastructure,
including energy. Without bold measures, there is going to be a long period of slow
growth in many industrial countries. This will make it much more difficult to face
growing competition from emerging markets, where there is no need for austerity
measures and credit markets are functioning better.
With so many challenges facing our policy makers, a lot of credit must go to those
who make the hard decisions. Who said the art of doing the right thing was easy?

Cecilia Hermansson

Economic Research Department
SE-105 34 Stockholm, Sweden
Telephone +46-8-5859 1000
ek.sekr@swedbank.com
www.swedbank.com
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Cecilia Hermansson
+46-8-5859 1588
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