The ‘whatever it takes’ mode of Central Banks
The global economy is experiencing the sharpest reversal since the Great Depression in the 1930s. In this exceptionally difficult situation, it is of utmost importance that policymakers implement a broad range of powerful support measures. As governments unleash unprecedented budgetary and fiscal efforts to combat the economic effects of the pandemic, one key risk they face is that interest rates on public debt soar in an uncontrolled way. This would rapidly result in unsustainable government debt levels and a self-fulfilling financial crisis. Luckily, however, central banks have very powerful tools at their disposal to prevent this from happening.
Back to their roots
That is the reason why central banks exist in the first place. Indeed, most central banks were initially set up to provide an answer to two problems, both related to the concern of financial stability.
- They had to ensure the stability within the financial system, as ‘bank runs' come with extremely disruptive consequences for the real economy. Central banks can break this downward spiral by providing enough liquidity to commercial banks and the financial system at large.
- A second historical role exists in guaranteeing that governments can easily finance themselves at any time. After all, situations may arise in which the private sector no longer has confidence in the creditworthiness of the government. This was painfully illustrated for example during the 2010-2012 Eurozone crisis. It is then up to the central bank to act as 'lender of last resort'. In other words, the initial logic behind the creation of central banks stems from concerns of financial stability. They were not established, as many people believe, to keep inflation in check. The latter concern is why, following the stagflation witnessed in the 1970s, central banks were granted a status of independence.
Supporting the economy
Of course, inflation is not what is on policymakers’ minds right now. It’s the risk of protracted economic weakness and deflation that deserves all attention. Ever since the 2008-2009 Global Financial Crisis central banks have taken up an increasingly important role in this respect.
As governments were busy reining in their budgetary deficits in the aftermath of the crisis, central banks had to keep monetary policy conditions loose to support economic activity and prop up uncomfortably low inflation expectations. In doing so, besides providing ample and cheap liquidity to commercial banks, most central banks including the Fed, the ECB and the Bank of Japan cut interest rates to zero (or even into negative territory) and also firmly pledged to keep rates low in the future (defined as forward-guidance). Moreover, they installed large-scale asset purchase programs by buying government, corporate and mortgage debt securities in financial markets (better known as quantitative easing or QE). Central banks have seen their balance sheets increasing by trillions of euros and dollars as a result. COVID-19 has forced central banks to drastically scale up these unconventional measures (which have become conventional over the last decade). These efforts are firmly tied to the objective of keeping long-term interest rates in check and stem the panic in financial markets.
Can they do even more?
The ECB announced a new €750bn program of bond purchases, mostly intended to contain borrowing costs for the hardest-hit countries like Spain and Italy. And according to ECB-president Lagarde, more will be done if necessary. The Fed already committed to unlimited balance sheet expansion for the foreseeable future. Central banks could even resort to more drastic measures.
In theory, from a purely economic point of view and leaving aside legal issues, it’s possible for central banks to directly finance the governments’ budgetary deficits. The biggest advantage of this approach is that national governments would not have to issue more debt in the first place. For heavily indebted countries like Italy this would be of great help. But in fact, all countries would benefit because it would make budgetary saving efforts over the next decade less severe.
It is even possible at a later stage - when the economic fallout can be assessed more properly - to go another step further and have central banks deliver a cheque directly to citizens. This would give a strong boost to economic recovery.
And this is reassuring…
To be clear, both direct monetary financing and ECB-cheques are not on the table now and it’s quite unlikely that these measures will be implemented anytime soon. It just illustrates that, despite all central bank action taken so far, central banks have not yet reached the limits of what they can do. Indeed, should the economy enter a devastating deflationary spiral, it’s good to know that central banks have ample ammunition left.