With interest rates at zero, what else can central banks do?by / June 16, 2016 / Leave a comment
Published in July 2016 issue of Prospect Magazine
In the decade before the financial crisis, world economic growth was 4.2 per cent. In the aftermath it declined to 3.2 per cent and a recent International Monetary Fund analysis predicted that it will stay stuck at this lower pace. In the short-term, prospects are improving in developed economies, but these positive signs are offset by a slowdown in emerging markets.
This is pretty disappointing. Concerns about inequality, low earning power and high unemployment among the young in many developed countries are politically toxic. There are signs of disillusionment with previously dominant political parties in Britain and abroad.
Problems in emerging economies are related to those in the developed world. Continued weak growth in developed countries has produced the low commodity prices depressing several of these economies. China’s rising indebtedness seems to mirror the example of the West.
This is a challenge for policymakers of the political centre, and a challenge to their economic consensus based around fiscal probity, low inflation, competitive markets and liberal trade policies. Yet as major central banks have already reduced interest rates to very low or negative levels, and budget deficits are high in many developed economies the question is whether anything can be done.
There is also disagreement about what the problems are. In the UK, some put slow growth down to a deficiency of demand. Others point to the big fall in the unemployment rate, and suggest that weak productivity growth is suppressing supply.
“If we don’t tackle inequality there is a risk that more extreme political groups could worsen the prospects for the less well-off”
The monetary policy of central banks is principally directed at demand (it can also have an impact on supply.) However, the Bank of England’s main interest rate is 0.5 per cent, which is near its effective floor. Other countries find themselves in the counterintuitive position of having negative interest rates. Central Banks cannot go any lower—what of their other monetary instruments? Martin Weale, a member of the Bank of England’s Monetary Policy Committee, which sets interest rates, recently argued that further quantitative easing (QE), where the Central Bank raises the level of money in circulation, did have the power to boost the economy further. (Britain’s QE programme currently stands at £375bn.) He was more cautious about the policy of forward guidance, where central banks give indications of future changes in interest rates. As for the policy of monetary financing, where central banks create money, which they use to pay for government projects, Weale see this as indistinguishable from QE. I agree with him.
Central banks are not quite out of bullets, and can also change the rules to make it easier for consumers to borrow money. But these monetary measures can only help to smooth the post-2008 path to recovery. Similarly, simply resorting to higher fiscal spending risks smoothing the pain across a longer period. If Britain steps away from Osborne’s self-imposed task of deficit reduction, additional public spending must be carefully thought through and not involve simply throwing money at infrastructure. The key is whether any additional spend will increase productivity growth.
The rise of populist politics may not yet form a real threat to the liberal economic consensus. But if we don’t tackle inequality there is a risk that, perversely, the policies of the more extreme political groupings could worsen the prospects of the less well off.
At the global level, better coordination between central banks would help. But at the domestic level, monetary policy can do no more than provide a couple of shots in the arm. The UK faces other big challenges (quite aside from the risk of Brexit), such as the ageing population and sharply rising costs of health and social care. The urgent questions of productivity and inequality have to be resolved fast. Fiscal rules and inflation targets alone are not up to the job.