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Will more drinks cure a hangover?

By Geoff Carmody - posted Friday, 13 March 2009


But forget the underlying causes - for now anyway (they’ll be important for structural reforms later).

The key point is that their effects are excessive debt and (until recently) unsustainably high asset prices.

However delivered, the sustainable long term solution therefore has three elements:

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  • overall, the world needs to get debt back to serviceable levels;
  • "serviceable" debt must have regard for underlying asset values against which that debt is secured, and income flows that provide the wherewithal to make the debt servicing payments; and
  • "underlying" asset values must be sustainable if lenders are to have confidence in the viability of their lending.

Here’s the rub.

At least some asset prices may still be too high. Sustainable asset prices - and a widely held belief that they are sustainable - are important ingredients in restoring confidence in the financial system.

Outstanding debt, overall, is still too high.

Meanwhile, debt-reduction - especially if it is chasing weakening asset prices as well - necessarily imparts a dampening effect on spending, thence output, thence employment, and so on in a “vicious circle” of slowing economic activity (or worse).

But this consequence is not easy to avoid. Ultimately, we can choose when we take the pain of adjustment (sooner and sharper, or later and more protracted), but not whether we must take the pain.

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Here’s where the policy dilemma arises. The transition to the longer-term solution is a very tricky road.

Unfettered action to reduce debt and allow asset prices to fall brings with it the risk of “overshooting”. That is, asset prices fall too low, more general price levels start falling, existing debt levels start rising in real terms (because they are set in constant dollar terms), resulting financial pressures lead to asset “fire sales”, further depressing prices, and so on. In “Goldilocks” terms, our adjustment pain - our “porridge” - gets too cold.

On the other hand, too much “pump-priming” in an attempt to shore up aggregate demand may blunt the needed debt reduction/asset price reduction process or wipe it out. In this case, we would put off the needed adjustment, and, worse, lay the groundwork for another, bigger, asset price bubble (and more general inflation) later. When this emerges and it becomes the priority policy problem, all the policy levers are switched to restraint, leading to a future (even bigger) “bust”. In “Goldilocks” terms, in this case our “porridge” stays too hot.

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About the Author

Geoff Carmody is Director, Geoff Carmody & Associates, a former co-founder of Access Economics, and before that was a senior officer in the Commonwealth Treasury. He favours a national consumption-based climate policy, preferably using a carbon tax to put a price on carbon. He has prepared papers entitled Effective climate change policy: the seven Cs. Paper #1: Some design principles for evaluating greenhouse gas abatement policies. Paper #2: Implementing design principles for effective climate change policy. Paper #3: ETS or carbon tax?

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Creative Commons LicenseThis work is licensed under a Creative Commons License.

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