Economics

George Magnus: The Great Deleveraging must be contained

George Magnus, Group Senior Economic Adviser, has published this morning his latest thinking on the progress of this episode (see attached). In his own words:

".... an end year assessment of where we are in the Great Deleveraging. The main focus is not so much on the economic data, which are as poor as we would expect, but on the comprehensive and complementary policy initiatives needed to make sure that the economic and financial crisis can be contained next year and beyond. The main conclusions are:

1) Banking system rescue plans launched in October check all the right boxes but there remains much to do. Banks still don't have enough capital from the current standpoint and with regard to future credit losses, and should not delever through excessive balance sheet shrinkage. The US could and should spend the rest of the TARP on recapitalisation.

2) The resumption of credit flows to 'good' borrowers is essential to contain economic and credit losses. The rescue plans cannot guarantee that protected banks will do so on the scale required yet, and so government initiatives will needed to provide or guarantee loans to small and medium size companies.

3) Fiscal stimulus programmes are an essential and complementary part of the official response. So far the European initiatives have been disappointing and half-hearted. The UK programme is more solid, though by no means overflowing. The US stimulus plan to be proposed by President-elect Obama's team around the time of his inauguration is eagerly awaited. It needs to offset the household balance sheet improvement, or roughly 4-5pct of GDP over 2 years.

4) Ultimately, if all the above fail or are slow to raise aggregate demand, there is a chance some countries will experience price and debt deflation, in which real interest rate and debt burdens rise. If that risk rose significantly, with policy rates at 0.5pct or so, central banks would have one last bullet in the form of quantitative easing. This need not involve debt monetisation to start with - but would be aimed initially at a targeted level of or growth in bank reserves, and other measures to lower the entire term structure of interest rates."