Are we running out of ammo?

The world’s major central banks have thrown just about everything at trying the limit the effects of the global financial crisis and support the subsequent recovery.

In their efforts to prevent what the northern hemisphere calls the Great Recession turning into another Great Depression, they have not only slashed official interest rates to extraordinarily low levels, but have been printing enormous sums of money and even, in some cases, setting negative rates – measures that only a few years ago were barely thinkable.

The concerted actions of central banks and national governments in the immediate aftermath of the Lehman Brothers collapse in September 2008 succeeded in preventing the economic downturn turning into something far worse.

But almost eight years later the recovery is still struggling to find traction. The World Bank recently downgraded its 2016 growth forecast to just 2.4 per cent[1], and the crunch on revenue is making it harder for many governments to wean themselves off debt and deficit. In the United States, public debt as a proportion of GDP is almost 105 per cent[2], while in Britain and France it is touching 100 per cent and in Japan it has topped 250 per cent.

Major central banks, meanwhile, are grappling with the legacy of ultra-low interest rates and ballooning balance sheets. The official interest rates of most are close to (and in Japan’s case, below) zero, and total assets held (excluding the People’s Bank of China) has reached US$11.8 trillion[3].

It is little wonder the International Monetary Fund recently warned that if there is another severe global downturn, “the needs could exceed the collective resources available”[4].

And the risks are not small.

A febrile world

The World Bank warns that the global economy is facing “mounting risks” from slow growth in advanced economies, stubbornly low commodity prices, weak global trade and diminishing capital flows[5] – concerns echoed by IMF Managing Director Christine Lagarde[6].

Even US Federal Reserve Chair Janet Yellen, who has generally adopted an optimistic tone about the outlook for the US and global economies, sees risks aplenty, including Europe or China “taking a turn for the worse”, a spike in oil prices, a resumption of the slide in commodity prices or a non-economic shock.

“In the current environment of sluggish growth, low inflation and already very accommodative monetary policy in many advanced economies, investor perception of, and appetite for, risk, can change abruptly,” Yellen says[7] – underlining Yale University economist Robert Shiller’s point that it is how people perceive, and respond to, such events that will be crucial in transforming something like an oil price hike into “a truly virulent economic disruption”.

What are the chances?

Former US Treasury Secretary Larry Summers puts the odds of the United States sliding into recession in the next year at one in three, and believes it is a better-than-even bet in the next two years.

The United Kingdom-based Resolution Foundation is similarly downbeat. It reckons that, based on the pattern of past business cycles, Britain has a one-in-three chance of enduring a downturn in the next five years, increasing to an 80 per cent chance by 2025[8].

This may be too pessimistic, but economists reckon there are several good reasons to expect that, sooner or later, there will be another downturn.

What to do?

Given how much central banks are already doing to support activity, worried policymakers are thinking hard about what else they can do.

One answer is to do more of what they are already doing – holding interests rates very low, expanding their quantitative easing programs, and providing forward guidance on the direction of interest rates.

But former US Federal Reserve chair Ben Bernanke warns there are limits to how low interest rates can be pushed, and the effectiveness of such a policy is likely to diminish over time, while the risks it brings with, such as property bubbles, are likely to increase[9].

There has been discussion of whether inflation-targeting central banks should raise their aim, lifting their goal from 2 per cent (in the case of the Bank of England) to create additional rate setting room. However, not only does this run the risk of cutting loose inflation expectations and undermining the hard-won credibility of central banks, it is not obvious how this would help stimulate the demand necessary to lift prices[10].

Copter cash

For almost 50 years the idea of ‘helicopter money’ has been kept in a box labelled ‘only open in case of emergency’.

Now, it is being dusted off and talked about seriously by influential economists including Bernanke and former UK Financial Services Authority chair Adair Turner.

The idea, first articulated by Milton Friedman in 1969, is to fund expansionary fiscal policy, such as a personal tax cut or government investment in infrastructure, from the balance sheet of the central bank, rather than by issuing interest-bearing bonds, as would normally be the case.

For Bernanke, the idea is appealing because the stimulus can be directed through multiple channels at once – funding public works, increasing household income and boosting inflation – without adding to the future tax burden.

“It is extremely likely to be effective, even if existing government debt is already high, and/or interest rates are zero or negative,” he says.

The fear has always been that, once helicopter money starts flowing, it will be hard to make it stop. If politicians get the whiff that they can fund pet policies without driving up taxes, the thinking goes, governments and central banks will struggle to ever turn off the tap.

But Turner says dividing responsibility between governments and central banks should help ensure it is only used in moderation, and in a way that is safer, and with fewer side effects, than running negative interest rates and huge quantitative easing programs.

Missing in action

Helicopter money is often talked of in terms of what more central banks can do, but in reality it is a cross-over policy that requires monetary and fiscal policy to work in concert – something that has rarely happened since the GFC struck in late 2008.

In the ensuing eight years, governments have left most of the work of rescuing economic activity to central bankers.

In the US, Europe, Australia, Canada and elsewhere governments, spooked by ballooning levels of public debt, have been intent on holding spending down rather than loosening the purse strings to help stimulate demand.

In more normal times, bodies like the IMF and the OECD would laud such restraint.

But the weight of economic advice is shifting and government austerity is out. In its place, governments are being urged to consider tax cuts, handouts, investments and structural reforms.

The fear is that if they do not, the world will become locked in a low-growth, low-inflation trap such as has ensnared Japan for the past 25 years.

Open the taps

Summers believes the major economies, particularly the US, Europe and Japan, are already experiencing what he calls secular stagnation, characterised by persistent shortfalls in demand due to long-term developments, particularly an aging population. As population growth slows, businesses and governments scale back investment, holding down employment and wages which, in turn, restrains consumption.

To break out of the cycle, he says, governments need to act.

“Fiscal policy is now important as a stabilisation policy tool in a way that has not been the case since the Depression,” Summers says[11].

As chief economic adviser at Allianz, Mohamed El-Erian put it, “central banks can’t go it alone anymore”.

“Officials of advanced countries increasingly are acknowledging that the problems facing their economies require a new response to take over from the overlong use of narrow, short-term tools,” El-Erian says.

The change in mood has been reflected in the acceptance by European creditors that Greece needs debt relief, as well as Germany’s warning against over-reliance on central banks, and policy prescriptions from the IMF and the OECD that urge governments to take on much more of the burden of supporting economic activity.

The IMF’s Lagarde says monetary policy needs support. While accepting that countries with high debt and low public sector savings need to work on consolidating their finances, “those with fiscal space should commit to ease fiscal policy further,” she says. Even those with tight finances could aim for a more “growth-friendly” mix of taxes and spending, particularly increased investment in infrastructure.

The OECD sounds an even more urgent note.

The global economy is stuck in a low-growth trap and “comprehensive policy action is urgently needed”, according to OECD Secretary-General Angel Gurria. “Reliance on monetary policy alone cannot deliver satisfactory growth and inflation”.

“Almost all” countries have scope to redirect public spending to more growth-friendly projects, he adds.

Money well spent

But it is not simply a matter of shoving money out the door.

Governments need to work out ways to ensure the funds they pump out are used here and now, when the economy needs it most, rather than being stockpiled and used in sunnier times, when they could amplify inflation risks.

They need to overcome the propensity of consumers and businesses to cut back on their spending when uncertainty reigns.

Households nervous about the economy and fearful for their jobs tend to save rather than shop. And without a lift in demand, businesses have no incentive to hire and invest.

There are also more traditional objections to government stimulus measures – that they crowd out private sector investment, often take too long to take effect (and becomes pro-cyclical), and that much spending is unproductive, swallowed up by bloated bureaucracies and diverted into political pet projects.

But Princeton University economist Alan Blinder, a former Federal Reserve Board member and Presidential economic adviser, finds none of these are insurmountable[12].

When an economy is weak, he says, the risk of government crowding out private sector activity is implausible.

Some argue that fiscal stimulus merely brings forward demand and does nothing to increase aggregate supply.

Blinder questions whether this is the case, pointing out that if it pulls more people into the workforce or results in productivity-enhancing innovation or investment, it deliver a permanent boost to capacity.

A thornier issue is what form government stimulus should take if it is to be effective.

Blinder says recent US experience gives some good pointers to what works and what doesn’t.

Tax cuts often top the list when politicians think of ways to stimulate growth, but Blinder’s research shows striking differences in their impact.

Tax relief aimed at consumers, particularly lower income households, like child tax credits, payroll tax holidays for employees and earned income tax credits added between US$1.24 and US$1.38 to GDP for each US$1 of tax cut during the depths of the recession in 2009, compared with just 32 cents for every US$1 from a permanent cut in the corporate tax rate.

Even more effective were transfers and payments like food stamps and the Cash for Clunkers program. The temporary boost in food stamps, directed at low income households, delivered an extra US$1.74 to GDP for every US$1 outlaid, and Cash for Clunkers (under which owners of old gas guzzlers were paid a subsidy to trade their car in for a new vehicle) was almost as effective – US$1.69 for every US$1.

The lesson, says Blinder, is that temporary measures targeted at liquidity-constrained consumers can deliver a big bang for the stimulus dollar.

This is not just a US phenomenon. Between October 2008 and May 2009 the Australian Government directed almost $21 billion in welfare payments and tax bonuses to low and middle income households.

It has been estimated around 40 per cent of households spent the money[13], and Australian Treasury estimated the handouts added more than 0.3 of a percentage point to GDP in the last three months of 2008 and 0.8 of a percentage point to growth in the first three months of 2009[14].

Well-targeted tax breaks and transfers, Blinder says, can help an economy strongly and quickly.

But, he adds, the longer a recession continues the more governments must look to other measures, like infrastructure investment.

Capital spending is typically viewed warily as a stimulus measure. Infrastructure projects can take a long time to get going, often a chunk of the funds is absorbed by intermediaries like state and local governments, and the money is spent slowly.

But Blinder says the longer a downturn persists, the more such support for activity comes into its own.

It has led some to suggest that governments maintain a list of infrastructure projects ready to go at a moment’s notice.

Breaking the chains

Governments are being urged to put their shoulders to the wheel not only through well-targeted spending, but also undertaking much-needed structural reforms.

In downturns, the instinct of politicians is often to try to save jobs by putting up tariffs, manipulating the currency and erecting other barriers to international competition.

But economists warn the benefits of such policies are illusory. By pushing up the cost of imports and slowing the transfer of skills and technology, the undermine competitiveness and productivity.

Instead, organisations like the IMF, OECD and the Resolution Foundation advise governments to resist intervening in exchange markets, foster competition in domestic markets, combat the effects of aging by boosting workforce participation and increase investment in productivity-enhancing infrastructure.

Bank of Queensland chief economist Peter Munckton says European governments, in particular, “should be working very hard in cleaning up their banking system”, which still labours under a huge overhang of debt.

El-Erian warns the longer politicians prevaricate, the worse the situation becomes.

“Today’s growth shortfalls become harder to reclaim even as tomorrow’s growth potential is undermined,” he says. “Every quarter [governments] wait to enact credible and comprehensive measures adds to the difficulty of removing the impediments to inclusive growth, and makes the political context even more complicated”.

Muckton says that, in the name of prudence, governments should act now: “We should be doing the backburning before the next firestorm arrives”.

* An edited version of this post was published in the August edition of In The Black. It can be viewed at: https://intheblack.com/articles/2016/08/01/is-the-world-prepared-for-the-next-economic-downturn

[1] http://www.worldbank.org/en/news/feature/2016/06/07/global-growth-forecast-again-revised-lower

[2] https://research.stlouisfed.org/fred2/series/GFDEGDQ188S

[3] http://www.yardeni.com/pub/PEACOCKFEDECBASSETS.pdf

[4] http://www.imf.org/external/np/pp/eng/2016/022216b.pdf; http://www.bloomberg.com/news/articles/2016-03-17/next-financial-crisis-could-overwhelm-world-s-defenses-imf-says

[5] http://www.worldbank.org/en/news/feature/2016/06/07/global-growth-forecast-again-revised-lower

[6] http://www.imf.org/external/np/pp/eng/2016/041416.pdf

[7] https://www.bis.org/review/r160607d.htm

[8] http://www.resolutionfoundation.org/publications/renewed-interest-the-role-of-monetary-policy-in-crisis-and-beyond/

[9] http://www.brookings.edu/blogs/ben-bernanke/posts/2016/04/11-helicopter-money

[10] http://www.resolutionfoundation.org/publications/renewed-interest-the-role-of-monetary-policy-in-crisis-and-beyond/