How To Prevent an Unruly Rush for the Exit

Policymakers from the Group of 20 nations and their market-based critics are missing the point about "exit strategies." The G-20 is right to announce that there will be no premature exits from macroeconomic stimulus and to reassure us that monetary tightening will be technically manageable. Yet it is overlooking the more complex challenges that economic policy must confront as a result of the emergency measures undertaken since mid-2007.

The exit strategy needs a wider remit and greater international coordination. There are three dimensions to what has to be done-monetary, fiscal, and financial-not just one. That is: monetary ease must return to normal interest rate policy; discretionary fiscal stimulus must shift to putting government budgets on a sustainable path; banks' guarantees and state-ownership stakes must be withdrawn. The G-20 discussion has largely ignored the complexities in two ways.

First, there is a challenge of sequencing, given the interaction between exit measures. Should fiscal or monetary tightening come first? When should re-privatization of banks take place? Would withdrawal of current extraordinary liquidity and deposit guarantees accelerate or offset monetary tightening? Should tax rises target or spare the financial sector?

We should hash out through the G-20 some agreed best practices. We can already offer some guidance based on past experience. Credible commitments to medium-term fiscal consolidation should precede monetary tightening to pre-empt Volcker-Reagan policy mismatches , which drive up interest rates. The desired structure of the banking system has to be decided before tax policies are changed, since it plays a key role in revenue creation-but actual bank privatization must wait until tax policies are clearly set, or else you end up driving away buyers. Other issues will need intensive consultation and study to clarify.

Second, there is a pressing need for international coordination of policy exits. The rapid cascade of increasing deposit insurance last October illustrates how the alteration of financial guarantees in one economy can affect all the others. Now, imagine that in reverse: initially, no country will want to be first to lift the guarantees but, once they are lifted, there will be a race to lighten the burden on banks. A similar dynamic could occur with bank privatizations: No one will want to be selling prematurely but, once sales begin, every government will want to sell its stakes before the market is saturated. An unruly rush to the exits is no better in a global financial crisis than in a crowded theatre.

On the monetary side, economies that tighten first may find their currencies appreciating and, in so doing, draw capital away from countries not yet strongly recovering. In turn, that may induce currency interventions to offset the spillovers, which could contribute to economic conflict. Given current trade politics, we do not need any more of that. Globally well-anchored inflation expectations have enabled aggressive policy easing and helped stave off deflation-yet they are well anchored in part because every major country is aboard; any significant divergences in inflation goals would erode that to everyone's detriment. Fiscal policy has the smallest international spillovers, and should receive the least attention.

International policy coordination of this kind is attainable as well as desirable. The practical approach to achieving it is three-fold. First, G-20 leaders must shed the notion that the gains from coordination are small and all are best served by each country pursuing its own policy measures as though alone. Second, the emphasis should be on discussion of policy measures and sequences, not on targeting outcomes (which cannot be well-controlled anyway). Third, the measures agreed should consist of pragmatic steps, not premature attempts at fundamental re-architecture.

Together, this means going for a pact on an exchange intervention standstill, rather than a scheme for ongoing surveillance, or for a trans-national coordinator of public sales of private financial assets, rather than a general rule on terms of public capital in banks. The challenge is getting through the exit together safely. If the G-20 successfully manages that process, the policy measures undertaken will provide strong building blocks for a more sound future regime-but let's get the exit strategy first.