Central banks will need new tools to combat the next downturn
Traditional monetary policy has had a number of unpleasant side-effects
Trying to predict a recession is a fool’s game. Expansions don’t die of old age. Various hard-to-predict accidents can put an end to them. A trade war — like the Smoot-Hawley tariff spiral in the 1930s — could be one such accident. The question is not when, but how, a recession plays out. And the policy response is key to the answer.
The most consequential policy mistake in economic history was the lack of a proper response to the financial crash of 1929. Central banks failed to recognise the impact of bank failures and debt-deflation dynamics, and monetary policy was too tight. So what could have been just a recession became a fully fledged depression. The lessons of this episode clearly guided the response to the global financial crisis of 2008.
Time will tell whether unleashing a trade war will turn out to be another historic mistake. But one thing is certain: policymakers no longer have the ammunition that has been required to respond properly to past recessions, let alone to full-blown crises.
Until now, monetary policy has essentially worked by lowering interest rates to stimulate demand and the appetite for risk. But a cursory glance at capital markets tells you that this isn’t an option today. A third of all government bonds globally — and two-thirds in Europe — have negative yields. Even in the US, which still enjoys moderate growth, long-dated Treasury yields are at or near record lows and could easily head towards zero in a recession. Traditional monetary policy has also had a number of unpleasant side effects, from boosting inequality to normalising low-to-negative rates, with adverse consequences for savers and banks’ profitability.
What other tools are available? Fiscal policy will play a major role in any future downturn, but will not be enough on its own. While there are powerful forces at play that will contribute to keeping interest rates low, this could change with large fiscal stimulus when debt is at record levels and rising. Moreover, historically, fiscal policy has not been flexible enough to be deployed quickly when needed.
In the next recession, a different policy framework will be required. This would involve what might be termed “going direct”: policies that put central bank money into the hands of public and private sector spenders, rather than relying on the incentives of lower rates.
Such a framework could be organised in a variety of ways but would certainly require closer co-ordination between fiscal and monetary authorities to ensure that fiscal expansion does not lead to an increase in interest rates. Over time it would help to restore a more normal rate environment, reducing the pressures of lower rates on savers and on the financial system.
To be feasible, a policy of going direct should have the following elements. First, a clear definition of the circumstances that call for such unusual policy co-ordination. Second, an explicit inflation objective that fiscal and monetary authorities are jointly held accountable for achieving. Third, a mechanism that enables the prompt deployment of productive fiscal policy measures, without the negative monetary policy impact on inequality. Could digital money offer something here? Finally, and critically, a clear exit strategy.
Such a mechanism could take the form of a standing emergency fiscal facility that would only be activated when monetary policy has been exhausted and inflation is still expected to undershoot its target. The size of the facility would be determined by the central bank and calibrated to achieve the inflation objective (including making up for past inflation misses), while the use of the funds would be decided by the fiscal authority.
It is, of course, a big jump from proposals such as this to an operational policy framework. A great deal of work remains to be done, and close attention will have to be paid to the respective legal and institutional set-ups of the various monetary jurisdictions. The European Central Bank will face particular challenges in this regard.
But, as I recall Timothy Geithner, then president of the New York Federal Reserve, saying in late-night emergency meetings in 2008, “Plan beats no plan”. Central banks increasingly find themselves in a liquidity trap. Business as usual is no longer an option.
If we plunge into another crisis, “going direct” will be the only policy option. But unless robust plans are drawn up now, such a revolution in macro policymaking risks devouring its own children by undermining the integrity and credibility of central banks, and unleashing uncontrolled fiscal spending further down the road.