A consensus is forming that policymakers should tighten fiscal policy, sharply, in countries with large fiscal deficits. Yet what makes these policymakers sure that business and consumers will spend in response to austerity? What if they find that it tips economies into recession, or even deflation?
In last weekend's communiqué of the Group of 20 leading economies, finance ministers and central bank governors stated that “countries with serious fiscal challenges need to accelerate the pace of consolidation”. Yet the world economy confronts two risks, not one: the first is, indeed, that much of the developed world is going to be Greece; the second is that it will be Japan.
As Adam Posen, outside member of the Bank of England's monetary policy committee, pointed out in a recent speech, fiscal contraction, along with persistent banking problems and insufficiently loose monetary policy, generated the negative shock in 1997 that entrenched deflation in Japan.* Many economic historians argue that the US made a similar mistake in 1937.