Monetary illusions
Central bankers are not magicians. Don’t count on them to conjure up remedies if the rich economies flag
Sep 2nd 2010
OVER the past few years the reputations of the rich world’s central bankers have fluctuated wildly. When the financial crisis struck, they were blamed for allowing the housing and credit bubbles to build, and for failing to foresee the bust. Later they were lionised for preventing a new Depression with bold actions to support the financial system. Now a third stage is at hand, one of dangerously outsized expectations.
With most governments unable, or unwilling, to offer more fiscal stimulus, central banks are left solely responsible for propping up the flagging recovery. The phenomenon is most obvious in America. Its economy has weakened, yet the default path for fiscal policy is a hefty tightening as the Obama stimulus wanes, the states slash spending to balance their budgets and the Bush tax cuts expire. With any discussion of remedies by politicians drowned out by partisan positioning before the mid-term elections in November, disproportionate hope is pinned on Ben Bernanke’s Federal Reserve. Hence the attention paid to his recent speech at Jackson Hole, which laid out, with great confidence, what further steps the Fed could take.
America is in the vanguard, but excessive faith in central bankers is unlikely to stop there. Some rich economies, notably Germany, have done well of late. But if America’s slowdown persists, they too will flag, particularly as fiscal austerity kicks in. In 2011, on current plans, the rich world is set for its biggest collective budget cuts in at least 40 years. Already there is talk of the Bank of England offsetting the pain by printing more money to buy more government bonds (a policy known as quantitative easing). The European Central Bank seems ready to maintain its special liquidity facilities for longer, and may be pushed to do more when the recovery slows. Currency movements will add to the pressure. The Bank of Japan this week said it would extend the availability of cheap loans to banks, in a bid to push down the yen.
In ordinary times it makes sense to leave the central banks to stabilise the economy while governments repair their finances. Cheaper money is an obvious offset to tighter budgets and, historically, many of the most successful fiscal adjustments have been matched by looser monetary policy. But these are not ordinary times. Central banks cannot cut short-term rates any further. And in many places the recovery is sluggish for a reason that also renders central banks less effective: economies are deleveraging as households, in particular, rebuild their savings and pay down debt. If people do not want to borrow, monetary policy, although not impotent, gives a smaller lift to the economy than it normally would.
Central bankers are also flying blind. With short-term policy rates at or near zero, getting more of a monetary boost means expanding a set of instruments whose efficacy, and side-effects, are ill-understood. Mr Bernanke and his colleagues have no shortage of proposals, from buying more government bonds to promising to keep interest rates low. But some ideas are untested. And those that have already been used, such as printing money to buy government bonds, are likely to suffer from diminishing returns. To make a further meaningful dent in bond yields, for instance, the Fed might need to buy another $1 trillion-2 trillion of government debt.
Not by the Fed alone
None of this means central bankers should not do what they can. They do have tools to try to ward off deflation, and should use them. However, they may not be able to live up to expectations. They can’t transform a sluggish recovery from a financial crisis into a vibrant one. Nor, if the expansion stumbles, can they prop it up alone.
Responsibility for boosting growth must be more evenly split with politicians. Only politicians can address the structural problems that are also holding back the rich world’s economies, such as the housing debt in America and the barriers to hiring in parts of Europe. Only politicians in countries, notably including America, that still have room for fiscal stimulus can ensure that it is used to complement monetary policy. And only politicians can couple stimulus with longer-term pension and tax reform, so that investors do not lose faith in sovereigns’ future solvency. Such a combination (however difficult given the electoral cycle in America) would avoid damaging the economy with ill-timed austerity now, and increase the effectiveness of bigger central-bank purchases of government bonds.
It is heady stuff for central bankers to be seen, once again, as saviours. But they cannot do it alone.
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