By Robin Marshall, director, Fixed income
Several monetary and fiscal policies have been announced within the G20 to combat the coronavirus shock; (1) a return of zero, or near, zero interest-rate policy (ZIRP), (2) resumption of QE asset purchase programs, with more flexibility (i.e., US Fed, ECB notably); and (3) fiscal support for corporates and households on wage bills and tax holidays. Therefore, the ECB announced less demanding credit rules and no limit on the share of country bonds that it can buy (compared to the previous 33% limit).
The programs have followed the model in the global financial crisis (GFC), with pledges to do “whatever it takes“ to prevent deep recessions. Some policy-makers have argued for a more radical approach, by cancelling private sector debt, and using the state’s balance sheet to protect citizens and the economy from the coronavirus shock (notably ex- ECB President Draghi). But so far, policy-makers have relied on the GFC playbook. This is unsurprising, given QE programs eventually worked, in reducing unemployment and restoring moderate economic growth, with modest inflation.
But the GFC shock was centred in the financial system, not the real economy. The credit crunch squeezed the real economy and caused deep recessions. The epicenter of the crisis was a dysfunctional financial system, and policy responses were tailored accordingly.
In contrast, the coronavirus shock is centered in the real economy, and a severe aggregate demand shock (probably the largest since WW2).
Recent policy responses may support aggregate demand and stabilize financial markets in the initial shutdown phase. But the impact on demand of much higher unemployment, cautious consumers and businesses unable to sustain investment, means further policy stimulus may be needed. This happened after the GFC, when several rounds of QE were required. In addition, the impact of more QE is likely modest, with monetary policy already close to Keynes’ “Liquidity trap”, and negative interest rates difficult for financial systems.
Further, conventional debt-financed stimulus risks taking debt/GDP levels to unsustainable levels in economies like Italy (debt/GDP already exceeds 130%). Some major economies enter the coronavirus shock with historically high public sector deficits to GDP (see chart below). After a decade of fiscal austerity, there is a risk consumers and businesses would fear further austerity, should the stimulus be debt financed, and restrain spending accordingly.
Government debt to GDP ratios
Source: BIS, as at December 2019 . Past performance is no guarantee to future results. Please see the end for important disclosures.
This increases the appeal of money-financed fiscal policy, or helicopter money (HM), especially as inflation is low and outright deflation a threat. HM combines fiscal and monetary policy to provide economic stimulus, financing fiscal stimulus with central bank money creation.
It might be said central banks pursue a version of HM already, in QE, by buying government debt in the secondary market, allowing the debt to sit on their balance sheets. But “conventional“ QE is not intended as a permanent increase in the money stock and is supposedly a temporary addition to the money stock, to be withdrawn by selling back the debt to the private sector, or allowing the debt to mature. Nor would HM be introduced when central bank balance sheets are enormous relative to GDP (with the possible exception of Japan), as the chart below shows.
Critics argue HM would risk high inflation rates by ending central bank independence, and it is forbidden in the ECB’s statutes, for example. So the governance process would need to include tight controls run by the central bank. But current extreme economic conditions may well require an extreme policy response of this nature.
Central Bank Balance Sheets (USD, Tn)
Source: FTSE Russell / Refinitiv, March 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
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