Expansionary Monetary Policy Is Not The Answer

by Samira Salwan

The state of the disarray caused by the Coronavirus Recession has sent central bank economists into a frenzy over potential policy solutions. The United States Federal Reserve Chairman, Jerome Powell, has overseen a 1.5% drop in the federal funds rate.


Economists fear that we have reached a global impasse in terms of growth and uncertainty has enshrouded the global economy. Many traditional stimulus tools have been criticized as ineffective and may not help whether the disaster we’re in.

Governments have been manipulating interest rates for several decades. In order to counteract slow growth and stimulate their economies, governments enact decisive changes to their monetary policies – policies that control a nation’s money supply in order for their currency to remain stable – in the form of interest rate manipulation.

Central banks choose to lower interest rates to promote borrowing and investing. In theory, this should spur business creation and consumer spending which leads to the creation of jobs, with the end goal being increased economic growth. But this is just a theory.


It relies heavily on the assumption of ceteris paribus- an assumption that has proven to be fatally flawed. Confidence is a fundamental pillar upon which our economies stand and faith in our global economy has begun to erode.


Even before the Coronavirus caused global havoc, Bridgewater Capital’s Ray Dalio stated that there was a 70% chance of a recession before the coming presidential election citing hubris and political uncertainty as key factors.

This general sentiment of uncertainty has prevailed globally. As firms become warier of economic collapse, the propensity of firms using federal credit for its intended purposes declines significantly.

In recent years, both businesses and consumers have tended to an error on the side of caution and stockpile this money instead of spending it. This is often done in the form of stock buybacks.


Stock buybacks inflate stock prices - a cause of the aforementioned stock market hubris - but do not contribute to the reduction of unemployment or the growth of the overall economy. Often, these firms choose to use the money in ways that will not be helpful to the growth of the economy, a critical pitfall of the expansionary monetary policy theory. The government views this as far from ideal.

From the government’s perspective, hoarding borrowed money does not help to increase economic growth and further augments a nation’s deficit. Monetary stimulus packages are expensive, particularly in countries in which rates are sub-zero and, in order to sustain this level of spending, some governments are forced to borrow funds.


This issue is particularly prevalent in Japan. Japan’s economy has stagnated after the 1990s and its government has attempted to use a number of monetary and fiscal stimuli policies to restore growth to the decelerating economy. In the mid-90s Japan’s bank rate was 6%, today it has plunged to -0.1%. The central bank of Japan is effectively paying other banks to borrow money from them.


The consequence of this excessive spending is excessive borrowing and Japan’s deficit has skyrocketed to 417% of its GDP.

In addition, the frequency of interest rate drops and the absence of impactful levels of interest rate drops, due to a lack of austerity measures in prosperous periods, has caused companies to become desensitized to minor decreases in interest rates.


Perhaps it will work to combat this recession, but it is not a sustainable strategy in the long term. There’s only so far south of 0% central banks can go.

There is significant debate over what can be done and no one has reached a conclusive answer as of yet. Many debates over whether we should turn to fiscal policies – enacting tax cuts and changing budget allocations – or enact targeted measures, such as increased social security benefits, to prompt further growth.

But policymakers must return to counter the core issue of plummeting confidence. This must be done by showing the populace that faith in their government institutions is warranted.

Governments must turn to regulatory measures and public work projects to combat future downturns because monetary policies are not the answer this time.


References:

1) https://www.reuters.com/article/us-hedgefunds-dalio/bridgewaters-dalio-sees-70-percent-chance-of-recession-before-2020-idUSKCN1G604T

2) https://www.investopedia.com/articles/markets/080716/why-negative-interest-rates-are-still-not-working-japan.asp

3) https://www.cnbc.com/2019/10/22/jamie-dimon-on-negative-interest-rates-economic-slowdown-recession.html


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