Economists at Morgan Stanley say that aggressive policy actions should mean the global economy avoids both depression and deflation.

“In recent weeks, a policy vacuum in Washington and terrible economic news had increased the ‘tail’ risks of prolonged recession and deflation. Not surprisingly, comparisons between the current crisis and the Great Depression or Japan’s Lost Decade multiplied,” the firm observes in a research note. However, it believes that comparisons between the current economic climate and those disasters are “greatly exaggerated”.

“To be sure, serious risks still point to a weaker economy, a longer downturn and the threat of deflation. And today’s sins of omission have been similar to the 1930s and the Lost Decade: Policy has yet to break the adverse feedback loop from the deleveraging of lenders’ balance sheets to the economy that is at the heart of this credit-crunch-induced recession,” it says.

“More importantly, however, those two earlier calamities also involved egregious sins of commission or at least delay. Tightening monetary and fiscal policy turned a serious recession into the Great Depression, and protectionism made it worse. Japanese authorities eventually embraced the right policies, including cleaning up bank balance sheets, but it took a decade to adopt them,” it observes. “In contrast, we believe that the Obama Administration will implement aggressive policy actions that reflect the lessons of those two events.”

Morgan Stanley sees three major lessons for policymakers from the Depression and Japan. “First, aggressively use macro policies to buy time for other needed policies to be implemented and to take effect. Second, employ policies to stabilize the financial system and attack the roots of the credit crunch. Finally, adopt measures to reduce the imbalances, especially in housing, that triggered the downturn,” it explains.

Policy steps to improve funding and credit markets must precede any rally in risky assets such as equities, the firm notes. “Aggressive, coherent policy steps to address that feedback loop have been taken over the weekend and are welcome in that respect. That the incoming Obama Administration is mooting a multi-year, US$500 billion fiscal plan testifies to their resolve to prevent dire economic outcomes. Investors should look next to stability in funding and then credit markets, and then finally to riskier assets, as they begin to anticipate better economic news,” it concludes.

IE