When a billion Pounds’/Dollars’ worth of stimulus becomes a drop in the ocean it is easy to begin to take the role of central bank policies for granted in recovering from an economic crisis. In fact, in the realm of economics and monetary studies there’s very mixed wisdom on the role of crisis era monetary policies just as there is fiscal or public sector support. Given that the policy toolkit continues to be developed and major central banks constantly create new forms of monetary stimulus, many would still consider the jury to be out with respect to the empirical evidence too. Still, let’s answer some fundamental questions that have recently been asked.
If you are faced with a problem of how to restart or stimulate an ailing economy you have several options. Amongst those are:
Regulatory – make it easier for private enterprise to conduct commerce with lower barriers to entry to stimulate economic activity.
Fiscal – Spend money at the public level and expand the government’s role in the economy. Government spending is a component of economic output (and therefore growth) and government spending on, for example, infrastructure projects will provide a boost to the economy. Everything from the eat out to help out scheme to the HS2 program constitute fiscal stimulus spending. Tax cuts also fall into this category with the logic that higher rewards for profit should encourage private economic activity.
Monetary – Monetary policy concerns anything money related – manipulating the cost and reward associated with holding money in its various forms and the plenitude of it in the financial system. During the rise of monetarism, this involved notions of controlling the money supply and thus controlling the economy. This was often achieved through the interest rate and even explicit money printing. Increasingly complex tools that broadly fit into the category of quantitative easing and asset purchases are mainstream tools across the globe today that fall within this category.
In reality, a holistic response to an economic crisis will include elements of each of these. For now let’s look at monetary stimulus and hope asset purchases fit within the pursuit of achieving economic restoration by manipulating the cost and availability of money.
Due to the expansion of the financial system across the global economy, financial stability has become ever more critical. Due to the interconnected nature of the economy, financial crises can easily spill into economic and even political crises, and vice versa with alarming speed. When the real economy is standing in front of a precipice, it is easy for financial conditions to deteriorate and likely cause a financial crisis. The financial crisis in turn is likely to stoke and exacerbate conditions in the real economy. To stop this doom loop, central banks intervene in order to stop the perpetual degradation of economic conditions.
Still seems a bit fuzzy and unjustified? Consider this example. When the pandemic (just one form of economic depression experienced in recent decades) hit, what did governments do to save lives and livelihoods? To name but a few public responses with immeasurable social impact they embarked upon a furlough program, several costly stimulus policies, cut stamp duty and have recently stent billions of pounds securing vaccine doses to inoculate the population several times over. But where did the money come from to accommodate such stimulus measures against a background of falling tax revenues? Debt markets! The government raised money by issuing bonds into the open market to raise money now for repayment at a later date. Had the market been left to its own devices as it showed us in the first days the pandemic took grip before emergency monetary support, the market for such a large and immediate volume of debt simply wouldn’t have been there. At best, the market for existing and new government borrowing would have been remarkably expensive harming the UK’s ability to respond to the crisis and even threatening its solvency. In response, the central bank(s of the world) stepped in to be a buyer of debt and treasuries in the open market in order to maintain financial stability and ‘reasonable’ borrowing costs so that an impending economic crisis did not spill over into a financial crisis thus preventing this doom loop.
Depending on who you ask, the central bank has anything from an infinite capacity to purchase assets and debt to no place whatsoever in financial markets. Since the financial crisis and an endless grind lower in the rate of interest globally, traditional tools for monetary stimulus (i.e manipulating the interest rate) have lost their potency. In a bid to still manage the economy using a monetary tool kit, the Fed and other central banks have begun directly becoming part of the demand curve in markets rather than seeking to influence it by becoming direct players in the market.
The central bank (again depending who you ask) doesn’t have to pay for things. It’s effectively a blank cheque institution where the price of its action is paid for by the value of assets, aggregate price level and money supply in the economy it oversees rather than its wealth. The images of gold lying beneath vaults in central banks is nothing more than an illusion ultimately these days. Rather a central bank has a tab or an IOU (I owe You) list that we call a balance sheet: assets that it has become the buyer of and provided the cash equivalent of to a market/public body.
As the Fed and other central banks have intervened in their own debt markets in order to preserve favourable financing conditions for the private and public sectors alike since the health crisis began, the size of that IOU list has ballooned. The Federal Reserve’s list of things that it has bought and holds on its books having provided the cash equivalent for now stands just shy of a whopping $8tn. This is almost double what it was at the start of 2020. The ECB’s stands at €7tn more than three times what it was by the end of the 2007/8 financial crisis. The unprecedented public response to the health crisis and the bill it has created means that central banks have felt the need to intervene more and be the demand in the market ever more frequently as public and private borrowing hits all time rates to survive the pandemic. The new challenge will be how to trim the balance sheet/IOU list when globally it amounts to close to a full year’s worth of global output.
Discussion and Analysis by Charles Porter