Four years into the financial crisis, Ken Rogoff, professor of economics at Harvard University, believes the biggest deficit global markets are facing is credibility, not credit.
“Markets can adjust to a downgrade of global growth, but they cannot cope with a spiraling loss of confidence in leadership and a growing sense that policymakers are disconnected from reality,” Rogoff wrote in the Financial Times.
Policy makers in both Europe and the United States have been assuming growth rates that will not materialize, Rogoff said.
“By far the main problem is a huge overhang of debtthat creates headwinds to faster normalization of post-crisis growth—that is why post-financial crisis growth is typically very slow," he said.
Rogoff said it's best to think of the global economy as going through a “Second Great Contraction” (the Great Depression being the first) involving credit and housing, and not just output and unemployment.
“For all intents and purposes, most European and US economies have never fully exited the downturn, with output per capita still below its pre-crisis peak,” he said.
Questioning the worth of more temporary stimulus and more government spending, given their impact on deficits, Rogoff believes it is time to clean up balance sheets while maintaining the integrity of the financial system.
“In the case of Europe, this involves very large debt write-downs in the smaller periphery countries, combined with a German guarantee of central government debt in the rest. In return, Germany will have to receive a disproportionate share of fiscal power in a more deeply integrated union, for at least as long as it is making substantial transfers,” said Rogoff
“In the case of the US, policymakers need to offer schemes to write down underwater mortgages, perhaps in return for other concessions such as giving the lender a share of any future home price appreciation,” he said.
Any reform also needs to grapple the with issue of pensions and health care, according to Rogoff.
“If policymakers can at least get the diagnosis right, it would be a major step on the road to recovery. After a long series of half-steps and mis-steps, policymakers’ options are narrowing, but they are not out of bullets,” said Rogoff