28 November 2019
Toothless Central Banks
Fiscal policy returns.
By Frank O’Nomics
The Keynesian vs. Monetarist economic debate supposedly ended some years ago. At every recent economic downturn the main responsibility for carving a path back to prosperity lay with independent central banks and their control of interest rates and the money supply. If economic activity was under threat, or inflation looked to be getting out of hand, interest rates would be adjusted to stimulate or constrain. The 2008 financial crisis saw an extra string added to these bows, with the advent of quantitative easing; if rates could not be reduced further, central banks would effectively print money by buying government and corporate bonds. Now, however, there are some big question marks over this approach and fiscal policy, controlled by politicians, is coming to the fore.
What has gone wrong with monetary policy? First, it seems that a sledgehammer has been used to crush a nut, and the prices of assets have been inflated by new money chasing a limited supply, with little going into investment for growth. Second, what do you do when the proportion of bonds held by central banks becomes unwieldy? Institution needs the bonds for investment products and banks need them as security – restricted availability causes problems and there are only so many government bonds that can be bought. Finally, and this is very much the case in the UK and the US, what happens when governments gets frustrated by the inability of monetary policy to produce results at an acceptable speed?
Like it or not the fiscal vs. monetary policy debate is being reopened, and the likelihood of future economic stimuli coming from tax cuts and government spending, rather than interest rate cuts and bond purchases, is rapidly increasing.
In the UK, whether we factor in the Labour Party’s commitment to spend an additional £83bn, or the Tories’ £3bn, the next government is going to be spending money. 6 months ago the starting point looked encouraging, with government finances looking healthier than expected. More recent data shows that this headroom in public finances has all but disappeared (government borrowing in October was at its highest level for 5 years). However, the momentum behind breaking fiscal rules hasn’t. Two members of the Bank of England’s Monetary Policy Committee have asked for a rate cut, but gaining a majority at the next vote may be hard to achieve if the post-election Budget heralds a fiscal stimulus.
The situation in Europe is a little different. Here the ECB seems to be actively encouraging government spending. Last week Christine Lagarde used her first big policy speech as the incoming president of the ECB to urge Eurozone governments to increase spending. While she pledged the continued support of the ECB, she asserted that it “cannot and should not be the only game in town”. Effectively, she was warning that the ECB is running out of scope to help. She emphasised the need for spending to be productive, with a focus on infrastructure, and said that there would be a review of the ECB’s policy objectives and tools. Whether this will mean pledging to keep rates lower for longer by compromising on inflation targets remains to be seen – and it is an approach that may not find favour with the German authorities. Nevertheless, her speech does highlight the need for a more coordinated approach between central banks and governments. The bigger problem, as ever, for European governments, is that each nation has a very different starting point when it comes to debt levels. If ever there was a need for spending on infrastructure it is in Italy, where this week a major road bridge collapsed – the second in 15 months. The problem here is that a weak economy is generating little tax revenue for a country that is already heavily indebted. At the end of last year Italian debt to GDP (at 134.8%) was twice that of Germany.
With the UK likely to increase spending regardless and Europe dragging its heels, what of the US? Here we have already seen 3 interest rate cuts this year in response to a potential slowdown. General activity and labour market data suggest that these cuts are somewhat pre-emptive, although supported by weaker inflation, and Fed Chairman Jerome Powell has said that further cuts near-term are unlikely. Some commentators highlight pressure to cut rates coming from President Trump. Such assertions are unfair in that Mr. Jerome Powell does not seem the type to bow to such pressure. However, if the real concern is that President Trump will cut taxes and/or increase spending, then Mr. Powell may feel that interest rate cuts are a preferable alternative. In a recent speech he highlighted his view that fiscal policy is on an unsustainable path and may limit the scope to respond in an economic downturn in the future.
An economic slowdown is apparent in the UK, US and Europe. The scope to react with monetary policy varies, but in general is becoming much more limited. The whole point about setting up independent central banks was to take politics out of the setting of monetary policy. If we are now moving to a world where fiscal policy is the only tool available, then politics is very much a feature of economic management. The only solace comes in the realisation that increased government borrowing creates more government bonds – at least there will be something to buy when quantitative easing has to start again…
