Central Banks Could Trigger a Crisis Unless THEY Get Fiscal (4 min read)
... Rather than Keep Pushing the Burden to Politicians
Central banks have been so successful with forward guidance and convincing the public that positive saving rates will soon be a thing of the past that individuals are leaping at what they believe to be their last opportunity to save with them. The issue with a ‘lower yields forever’ scenario is that one needs to save a lot more to maintain living standards upon retirement, and a collective increase in precautionary savings lowers final demand, in turn constraining investment and resulting in an even worse macroeconomic outlook. This is a typical case of individual rationality breeding collective irrationality and the reason why I believe Nobel-prized economists’ models are broken.
Monetary policy – once thought to be a rectifying stimulus – has not only become impotent in the Eurozone and Japan, it has turned counterproductive. For the first time in history, lower rates have literally become contractionary.
Get Fiscal or Get a Crisis
In such a problematic scenario, we need sovereign intervention or we risk free markets triggering a financial crisis. The right macro response would be for sovereign demand to substitute itself to private demand in order to boost aggregate demand and absorb part of the extra saving glut. After all, the main beneficial effect of the collapse in global yields is to render global fiscal levers more potent by stabilizing and in some cases shrinking debt ratios effortlessly, thereby inviting fiscal stimuli. Today, even though DM sovereign debt levels are much higher than before the global financial crisis, the ratio of interest expense to GDP is often lower than before the crisis. This is especially true in the euro-area.
Need Monetary and Fiscal Coordination
DM central banks (outside the US) can still facilitate the next stimulus but they can no longer deploy it on their own. Forward guidance of low-for-long must give way to a credible framework for fiscal-monetary policy coordination because this is the only credible way forward to boost potential growth and inflation expectations.
There are many ways this could be implemented legally across the globe. We could see governments issue debt permanently monetized by the Central Bank to finance tax rebates. As controversial as it may sound, monetary financing of fiscal expansion is not new. It was widespread until the early 1980s until controlling hyperinflation became the primary focus and central banks were made independent with a mandate to limit inflation.
The bottom line is the answer to the next downturn will not be purely monetary. Inevitably, the division between monetary and fiscal policy will become increasingly hazier.
Transparency Will Help Term Premia
My strategic point is that if such policy mix considerations could just be floated publicly and their framework outlined, this would remove the risk of a persistent liquidity trap and permanently negative real and nominal rates. The result would be a more balanced risk distribution for inflation and policy rate expectations and a return of term premia. It would also increase the global equilibrium rate of interest rates. It is the absence of concrete and efficient countercyclical policy tools – an alternative to conventional or unconventional monetary policy – that is causing markets to sound alarm bells and collapse term premia and yields along global yield curves as savings rush to find a suitable shelter.
Bank of England’s Carney Gets the Joke
In a key speech delivered on 23 August in Jackson Hole entitled, ‘The Growing Challenges for Monetary Policy in the Current International Monetary and Financial System’, Bank of England head Mark Carney urged an evolution in the global monetary framework:
‘The growing risk of a global liquidity trap puts a high premium on getting more than just monetary policy right. Limited space for monetary policy to respond to adverse shocks means more of the burden for supporting jobs and activity will fall to fiscal policy. Though some may be tempted to resort to protectionism, such policies would merely serve to make the problem worse.’
We are still some way from cooperation, pushing the burden of stimulating activity to fiscal authorities is elusive as government-led fiscal expansions, whilst necessary, cannot be sufficiently reactive and nimble. A ballooning digital account at the Central Bank for governments or even people would fix this problem by making fiscal authorities’ firepower more visible and quantifiable. It is now time for action and cooperation rather than just words and I have high hopes that the President of the ECB, Christine Lagarde, can forge ahead on this crucial matter, perhaps even working towards building an international consensus.
This opinion piece forms part of Juliette Declercq’s recent wide-ranging strategy report entitled “Change is the only constant”. In the report, she also discusses whether global equity markets will crash if yields stop falling? And whether a global recession is avoidable. She also formulates specific macro investment ideas around these themes.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)
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