A balanced policy approach As I weigh the evidence, I believe we are in a liquidity trap and favor the prescription of continued accommodation. But I recognize that I could be wrong. Central bankers have incomplete information, and sometimes are confronted with very different views of the forces driving the economy. This is especially true in the difficult circumstances we currently face. Instead of a liquidity trap, some have posited that we are in an economic malaise that reflects “structural factors” (such as a job skills mismatch) and that the economy today is actually functioning close to a new, more dismal productive capacity. I have discussed this very pessimistic “structural impediments scenario” in other forums.1 If this scenario is true, then further monetary accommodation will only lead to rising inflation without much improvement in unemployment. Those subscribing to this view warn of repeating the mistakes of the 1970s. At that time, the Fed did not understand that the changing structure of the economy had caused the natural rate of unemployment to rise. Too much accommodation during that time only served to raise inflation and inflation expectations. Although I do not find this structural impediments scenario compelling, as a prudent policymaker, I must at least consider its possibility. Without a clearer picture of whether we are in the midst of structural change or a liquidity trap, I favor a monetary policy strategy that balances the two risks of dismally slow growth on the one hand and creeping inflation on the other.
Earlier this week, the Central Bank published a report on Iceland’s underlying external position, in which it addresses the question of whether Iceland is facing a debt sustainability problem or a balance of payments problem as I have just defined them. But in order to answer that question, it is necessary to peer through the settlement of the estates resulting from the financial crisis – a process that is nowhere near completion – and correct for the effects of certain international corporations operating in this country. These companies have a profound effect on Iceland’s international investment position as measured according to international standards, but they would have a negligible impact on the state of the domestic economy if they defaulted on their debt. As a result, the task requires a great deal of estimation and entails some uncertainty, as previous findings have shown. The estimates are now more reliable than before, however, as time has clarified a number of factors concerning the failed banks’ estates and analysts have now gained access to the best available data. The results are the same as in previous appraisals, however, in that there are no signs of a debt sustainability problem as I have just defined it. Iceland’s net underlying debt position is estimated at 60% of GDP, the lowest since 1999. Furthermore, it is lower than that of many countries that no one would claim faced a sustainability problem. New Zealand’s net debt position, for instance, has hovered around 80% for more than one decade.