Monday 20/05/2019

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From lender to spender of last resort?

Chief Economist

Nearly eight years after the start of the Global Financial Crisis, global economic activity remains subdued and inflation mostly surprises on the downside. In general, despite record low policy rates and unseen expansion of the monetary base, central banks continue to struggle to meet their inflation targets. Encouragingly, a global shift away from budgetary austerity is underway. That said, talk is still cheap. More fiscal stimulus is what the doctor would order when monetary policy is constrained by the zero lower bound.

Evidence from recent experiences in Japan and the Great Recession have been proving Milton Friedman wrong. Friedman argued that monetary policymakers could always control the money supply and as such he denied the possibility of a liquidity trap, a situation wherein monetary policy loses efficiency as bonds and cash become almost perfect substitutes when interest rates are close to 0%. This insight is part of standard economic policy since the 1930s but was largely ignored more recently.  

That does not mean of course that monetary policy has been completely useless, as some observers would argue, on the contrary. Counterfactual research finds that non-conventional policy measures deserve credit for its accomplishments in terms of tempering deflationary forces and supporting lending. Critics of low and negative interest rates argue that this situation is truly artificial and therefore should be reversed. All too often, however, they tend to forget that monetary policymakers try to target real interest rates that are consistent with healthy economic activity further down the road. This means they have to set interest rates somewhere. This has been nicely explained by the American economist Kocherlakota in his blog post ‘easy money is like insulin’. One could of course always disagree with policymakers on where that level should be given actual and expected future economic conditions. But, importantly, that almost never seems to be the source of the criticism.

A new study from the IMF finds that the ECB’s adoption of negative interest rates has been successful, at least so far, in easing financial conditions. That said, it also acknowledges the limits of this negative interest rate policy and argues that further policy rate cuts could bring into focus the potential trade-off between effective monetary transmission and bank profitability. Lower bank profitability and equity prices, in turn, could pressure banks to reduce lending, especially those with high levels of troubled lending.

The upshot is that monetary policy can only do so much in the current macroeconomic environment. Encouragingly, comments from G20 leaders and international institutions like the IMF and the OECD as well as the ECB suggest that a shift away from fiscal orthodoxy is taking place. In recent days, this has been illustrated for example by Japan’s newly announced fiscal stimulus package or the fact that the European Commission supported the Council’s decision not to impose fines on Portugal and Spain after missing their 2016 fiscal targets. Of course, these efforts remain quite modest so far and there is an important difference between shifting away from fiscal drag and really engaging in a coordinated fiscal stimulus program. The latter still remains to be seen but from an economic point of view at least this makes sense as we have argued before.

Undoubtedly, moving in this direction of fiscal spending, one can expect criticism to rise also. Many observers will argue that this Keynesian approach of deficit spending is not a good idea. But actually, Keynes would not agree that it is about ‘deficit spending’. Instead, he would have preferred the term ‘deficit-reduction investment’ spending. Why? In the current economic environment, government spending creates new economic activity, income and jobs. As a result, the government’s tax base increases while expenditures on benefits reduce. Moreover, the overall impact on the economy is amplified through what is called the multiplier process. Ample research has shown that these multipliers are pretty large in a liquidity trap.

The Unites States has arguably made the most economic progress in recent years and is now closer to full employment, implying that the fiscal multiplier might be lower given a possible crowding out effect. The Eurozone, on the other hand, is still nowhere near full employment so that the case for investment spending is still overwhelming.  Unfortunately, from a practical perspective, the probability that (divided) Europe will adopt a meaningful fiscal plan anytime soon looks smaller than in the United States where both presidential candidates have pledged to invest more.

Will policymakers move from lender to spender of last resort? Admittedly, the question misses the point. It’s not about monetary or fiscal policy but instead about the right policy mix of monetary and  fiscal stimulus. In the past few years, the budgetary component has mostly been neglected. And when it got any attention, it was mostly about balancing the budget. This could and should change. The question is…will it?