by Calculated Risk on 9/16/2009 11:48:00 AM

Nouriel Roubini writes: Desperately seeking an exit strategy

[T]he key issue for policy-makers is to decide when to mop up the excess liquidity and normalize policy rates – and when to raise taxes and cut government spending, and in which combination.

The biggest policy risk is that the exit strategy from monetary and fiscal easing is somehow botched, because policy-makers are damned if they do and damned if they don't. If they have built up large, monetized fiscal deficits, they should raise taxes, reduce spending and mop up excess liquidity sooner rather than later.

The problem is that most economies are now barely bottoming out, so reversing the fiscal and monetary stimulus too soon – before private demand has recovered more robustly – could tip these economies back into deflation and recession. Japan made that mistake between 1998 and 2000, just as the United States did between 1937 and 1939.

But if governments maintain large budget deficits and continue to monetize them as they have been doing, at some point – after the current deflationary forces become more subdued – bond markets will revolt. When that happens, inflationary expectations will mount, long-term government bond yields will rise, mortgage rates and private market rates will increase, and one would end up with stagflation (inflation and recession).
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Getting the exit strategy right is crucial: Serious policy mistakes would significantly heighten the threat of a double-dip recession.

In the short term - probably through most or all of 2010 - with the sluggish recovery, high unemployment and overcapacity, the major concern of policymakers will continue to be deflation.