In the process, the role of states and governments in economic activity will be vastly expanded.
Traditionally, central banks have been the lenders of last resort, but now they are becoming the lenders of first and only resort. As banks curtail lending to each other, to other financial institutions and to the corporate sector, central banks are becoming the only lenders around.
Likewise, with household consumption and business investment collapsing, governments will soon become the spenders of first and only resort, stimulating demand and rescuing banks, firms and households.
The long-term consequences of the resulting surge in fiscal deficits are serious. If the deficits are monetized by central banks, inflation will follow the short-term deflationary pressures; if they are financed by debt, the long-term solvency of some governments may be at stake unless medium-term fiscal discipline is restored.
Nevertheless, in the short run, very aggressive monetary and fiscal policy actions — both traditional and non-traditional — must be undertaken to ensure that the inevitable stag-deflation of next year does not persist into 2010 and beyond.
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