Stephen King: The five economic questions finance ministers should answer

There are a lot of difficult hurdles still to cross before we can be sure that recovery is strong enough

Just over halfway through the year, summer holidays approaching, time to take stock. Central bankers - at least those from the northern hemisphere - will be heading off to the seaside hoping that they've done just enough to secure a decent recovery in economic activity. Finance ministers will also be keeping their fingers crossed. They know that any failure of monetary policy will leave them facing awkward choices. If growth doesn't rebound, they will be facing tax shortfalls that might require higher tax rates, spending cutbacks, higher borrowing or, possibly, a combination of all three.

Luckily for them, the markets are on their side, at least for the time being. Rapid gains in stock prices over the last few weeks and rising bond yields suggest that investors are becoming increasingly confident about the outlook for economic growth. If this is right, a lot of people will be very happy. Alan Greenspan's reputation will, once again, head into the stratosphere. George W Bush will begin to relish the thought of next year's Presidential election. Gordon Brown will be able to look forward to many more years of extra spending on public services.

Beyond the summer, however, more work will be required. Policy makers simply cannot afford to rest on a combination of their laurels and the increased optimism within financial markets. In my view, there are a lot of difficult hurdles still to cross before we can be sure that recovery is both strong enough and sustainable enough to allow policymakers to take a breather.

Here are five questions that might be worth asking policymakers. They may not want to provide answers but the questions do highlight a number of threats to the current wave of optimism.

First, can we be sure that the deflationary threat has gone away? The reason for asking this question is obvious. Whether or not there is a short-term cyclical recovery, deflation still provides a longer-term threat. After all, inflation rates are still falling and, for most central banks, inflation today is too low rather than too high. In the old days, we always used to think about inflation as a consequence of growth. Now, though, we should be prepared to reverse the causality. Deflation doesn't always matter but it is a big problem when there's lots of debt about. Deflation raises real debt levels which, in turn, undermine the ability of an economy to grow. What, then, will central banks and governments do if inflation carries on heading ever lower?

Second, can we be sure that financial "imbalances" are entirely benign? This is an obvious point. The US has embarked on a significant loosening of both monetary and fiscal policy that will probably leave the budget deficit eventually rising beyond 5 per cent of GDP - and this is no ordinary GDP, it's the GDP of the biggest economy in the world. The problem with this approach is the current account deficit. The US current account deficit was big before all this additional loosening came through and it's now bigger still. Should we worry about this? In one sense, this is a bigger problem for the rest of the world than for the US. The US is in the enviable position of being able to borrow from everyone else in dollars so if the current account deficit can't be sustained, the result is capital loss for everyone else and only a mild slap on the wrists for the US. And once the world recognises this asymmetry, will the US ever again seem like such an attractive place to invest in?

Third, if growth really does not pick up, will finance ministers be prepared to tolerate ever-rising budget deficits? The US has already admitted that its deficit is heading rapidly higher. Japan already has a whopper of a deficit. Europe may be heading in the same direction. I still think that, stability pact or no stability pact, many European countries are simply not prepared to let their deficits rise too rapidly: after all, individual countries do not have access to the printing press - the ultimate solution for fiscally wayward politicians. Nevertheless, we appear be moving to a world of big government borrowing. Is this sustainable? And what happens if it is not? To date, there really hasn't been a significant debate on the merits or otherwise of heavy government borrowing: politicians are still in denial.

Fourth, does anyone think that policy co-ordination is a good idea? Listening to the views of leaders on either side of the Atlantic, co-ordination seems a long way off. Americans blame Europeans - and, for that matter, the Japanese - for the woes of the world economy. Europeans, however, see America as the root cause of the world's problems. The bubble sucked in too much capital and the US now wants to deal with the hangover through dollar depreciation. Dollar depreciation contributed to Japan's dislocation in the late 1980s and through the 1990s: could it now be doing the same thing for Europe? Put another way, is anyone prepared to spell out the consequences of a failure to co-ordinate?

Fifth, for those countries that need it, can structural reform take place without wrecking the economy in the process? Think back to the Thatcher reforms. Not very nice for many people, but the economy emerged in a healthier position than before (a lot of questions still remain on the Thatcher legacy as it affects public services but I see few people saying that we should go back to the good old days of the 1970s - other than diehard fans of the Bay City Rollers). The Thatcher reforms worked in part, though, because they delivered quick benefits to large parts of the economy. In particular, as inflation fell away, people's savings ended up higher in real terms, leading to a dramatic boost to consumer spending. Could Germany today achieve the same trick? The problem is the starting point. Chancellor Schroder's reform plans sound very interesting but it's not just a case of ultimate gain: it's also an issue abut how much short-run pain. And with inflation threatening to turn into deflation, Germany may never get to the point where supply side reforms really pay dividends.

So, as I head down to the South of France, I have my questions prepared. Should I bump into one of our policy-makers, I will know what to say. Will they have the answer? Well, they might, but I'm not sure that they would necessarily want to share it with me or, for that matter, anyone else. Why upset a glorious summer? Instead, wait a while, hope that optimism is retained and have a few glasses of chilled rosé. The hard work still has to be done but at least there's a bit of time to have fun in between.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com