There is an ongoing debate among global policymakers about when and how fast to exit from the strong monetary and fiscal stimulus that prevented the Great Recession of 2008-2009 from turning into a new Great Depression. Germany and the European Central Bank are pushing aggressively for early fiscal austerity; the United States is worried about the risks of excessively early fiscal consolidation.
In fact, policymakers are damned if they do and damned if they don't. If they take away the monetary and fiscal stimulus too soon - when private demand remains shaky - there is a risk of falling back into recession and deflation. While fiscal austerity may be necessary in countries with large deficits and debt, raising taxes and cutting government spending may make the recession and deflation worse.
On the other hand, if policymakers maintain the stimulus for too long, runaway fiscal deficits may lead to a sovereign debt crisis (markets are already punishing fiscally undisciplined countries with larger sovereign spreads). Or, if these deficits are monetised, high inflation may force up long-term interest rates and choke off economic recovery.
The problem is compounded by the fact that, for the last decade, the US and other deficit countries - including the United Kingdom, Spain, Greece, Portugal, Ireland, Iceland, Dubai, and Australia - have been consumers of first and last resort, spending more than their income and running current-account deficits. Meanwhile, emerging Asian economies - particularly China - together with Japan, Germany, and a few other countries have been the producers of first and last resort, spending less than their income and running current-account surpluses.
Overspending countries are now retrenching, owing to the need to reduce their private and public spending, to import less, and to reduce their external deficits and deleverage. But if the deficit countries spend less while the surplus countries don't compensate by savings less and spending more - especially on private and public consumption - then excess productive capacity will meet a lack of aggregate demand, leading to another slump in global economic growth.