EFA (45): Exit strategies

Over the past year, the term exit strategy has entered the vocabulary of economics. But what exactly is such a strategy? This is the topic of the 45th item in our regular Economics for Amateurs (EFA) series.

Wikipedia defines an exit strategy as "a means of escaping one's current situation, typically an unfavourable situation". In military contexts, the term is used to refer to a plan for withdrawing from a war, for example in Iraq.

In business, an exit strategy can refer to a plan to sell an investment in a particular company — sometimes called "cashing out" — or a plan for a company to withdraw from a specific market.

In economics, an exit strategy is something else again. It is a plan by a government to withdraw its stimuli to demand. As the major economies fell into recession, governments and central banks took action to offset the private sector's reduced demand for goods and services.

This action consisted of two main parts: fiscal policy and monetary policy. Fiscal policy is a government's tax and spending policies. By cutting taxes and increasing spending — or simply allowing tax revenues to fall and spending on unemployment benefits to rise — governments can increase demand in general.

There have also been policies to increase the demand for specific goods, such as cars under the "cash for clunkers" schemes. The result of all these policies is a significant increase in government deficits.

The main active policy, however, has been monetary policy. With interest rates already virtually zero, central banks, such as the Federal Reserve, the Bank of England and the European Central Bank (ECB), had to take other action to maintain demand.

What they have done is simply to create money electronically on their accounts — although it is often referred to as printing money — and used this money to buy bonds from the government and private sector.

This unorthodox process is known as quantitative easing (QE) because it increases the quantity of money (the money supply). In this way, central banks have pumped liquidity into their economies to encourage banks to lend to the private sector and thus avoid a credit crunch.

The process has been successful in helping to avoid a more serious recession. But "printing money" has the potential danger of creating future inflation. This is why governments are now looking for exit strategies to reduce or stop these policies.

The Bank of England has already signalled an end to its quantative easing, after spending around £200 billion on bonds.

The problem for governments and central banks is timing and speed, as it is with all types of exit strategies. When and how quickly should the stimuli be withdrawn? As the Financial Times wrote recently: "central banks must present a credible exit stragtegy but at the same time not look likely to put it into effect too soon".