By now there are little doubts we are heading into severe economic recession. Probably the worst we have experienced in a few generations. Can central banks still have a leading role in saving the economy? Will their actions change the global financial framework we knew?
Every business cycle ends with one of those three events occurring:
- economies are getting too hot and central banks have to tighten monetary policy ending the cycle;
- there is an oversupply of goods and services which is not met with demand and companies start to scale down the business;
- external shocks (natural disasters, wars, etc.).
COVID-19 pandemic belongs to the last group. However, the shock came at a time when we were very late in the business cycle, and most financial assets were already overvalued. Years of ultra-low interest rates and abundance of cheap financing pushed many investors to allocate their capital to overly risky investments.
Every time the economy faces a downturn, the role of a central bank is to provide support and encourage people and businesses to spend. Usually, central banks do it by encouraging banks to lend money to the real economy.
There are three main tools that central bank has at its disposal:
- Policy rate — in other terms, its the cost of money. By lowering interest rates, the central bank can reduce the cost of credit for banks, which should later be passed on lower interest for loans.
- Liquidity measures- whereas the policy rate is about the cost of money in the system, this measure is about the amount of money in the system. In regular times the central bank can control how much money is floating in the system by setting policy rate and reserve ratio requirements (which regulates how much credit can banks create). These days when the functioning of the markets is interrupted, central banks have to intervene more actively.
- Quantitative easing. A measure which came into a standard stool box after the Great Financial Crisis in 2007–2008. Central banks are buying government (and corporate) debt and hence improving liquidity and lowering the costs of credit. They also encourage investors to take more risk when everybody is scared.
Most central banks in 2020 found themselves in a situation when they can’t stimulate economies by cutting rates enough because they are already close to zero or even below. There is a limit to how far negative rates can go as it becomes counter-productive at a certain level.
The other challenge that central banks face with a current downturn is that the root of it is not in the financial sector as in 2007. This time the problem started in the real economy. Once the whole countries are locked down, most of the businesses stop generating revenues. People stop spending money. Without revenues, companies are unable to cover costs and are forced to lay off people. As people lose their job, they can’t afford to buy goods and services. The vicious circle keeps going. If this situation lasts for long enough, we are going to have a wave of bankruptcies and radically higher unemployment (first signs of that happening are already visible, and they make the prospects terrifying).
The problem is lack of income in the real economy, not a lack of credit in the financial sector. Central banks can address the latter, not the former.
As such, the role of central banks is quite limited. Their ammunition is limited, and they lack proper instruments to respond to this kind of problems. The central bank can encourage banks to make loans to businesses, but they can’t replace the lost income of companies and households.
That is why the fiscal policy is crucial in handling this crisis, more than ever. Governments around the world correctly recognized the seriousness of the situation and came up quickly with significant fiscal measures to support economies. Where businesses and consumers stop spending the governments have to fill that gap. There is a crucial question if the packages already presented will be enough to balance the economic hit (probably not). It is also questionable whether the aid will reach those who need them the most — small and micro companies, and workers who will be laid off. (It is much easier to bail out big companies, but they are much better positioned to weather this storm). However, the scale of governments intervention is impressive by all accounts.
There is also an unprecedented reaction from the central banks. The scale of bond buying that major central banks already announced (quantitative easing) do not have any comparisons in history.
There are three main reasons why these actions are crucial to helping the economy at this stage:
- Confidence. The root cause of this downturn came from the real economy. Yet, given the over-valuation and over-leverage in many segments of the market that turned into the most abrupt sell-off in the markets since 1929 (yes, 2007–2008 is not a benchmark already). Quickly evaporating liquidity exacerbated volatility. The moves were so quick and so dramatic that central banks had to use all available tools to avoid spiralling into total market meltdown.
- Proper functioning of markets. Right now, the most important thing is to regain the proper functioning of markets. Those investors who need to reduce their risk should do it without putting the whole financial system at risk of collapsing. It does not mean the market sell-off should stop. It means that buyers and sellers should be able to transact in the market. There were severe problems in doing so in the last few weeks. There are signs that this problem is already being solved.
- Monetizing debt. Most governments are highly indebted already. New fiscal spending later or sooner will have to be financed with higher borrowing. It is going to be a massive challenge in the future. However, for now, the most pressing issue is to save the economy and protect people. The best way the central banks can help with that is to buy government debt and make sure interest rates don’t rise unintentionally. It is the right thing to do now. Yet, the sustainability of those policies in the long term is an open debate.
We are operating in the most uncertain environment. Nobody knows how this is going to end because we don’t know when the initial problem (epidemic) will be stopped. However, I am quite confident that we are observing one of the biggest shift in the global financial framework in decades.
It’s too early to say how that new regime might look like exactly. We are heading into a world of new coordinated monetary-fiscal policies. That means that monetary financing (central bank buying government debt) is becoming new normal. Independent central banks whose main goal was to keep inflation in check is probably becoming a thing of the past. Public debt around the world will rise to levels which are not sustainable in the long run. But there is no other way for authorities trying to avoid catastrophe in the short term.
The current role of central banks is to make these temporary conditions hold until a new framework is developed. Financial suppression will be dominant for the years to come. Let’s hope we can figure out the solution relatively fast.