Commentary on Political Economy

Tuesday, 24 March 2020


Central banks must evolve to help governments fight coronavirus They need to make sure interest rates don’t rise in an uncontrolled way PHILIPP HILDEBRAND

 The challenge of responding to the devastating impact of coronavirus is a defining moment for this generation of economic policymakers. Part of that must be a reappraisal of central bank mandates. As governments unleash huge fiscal efforts to combat the economic effects of Covid-19, one risk they face is that yields on government debt start to soar. If that happens, it would undermine the entire public policy response to the coronavirus by making government debt more expensive. Central banks inevitably will be required to ensure that does not happen. Price action in financial markets already has been extraordinary.

Global equity markets have fallen more than 25 per cent in a month. Over the same period, the US equity market closed up on only a handful of trading days. This exceeds even the darkest days of 2008. This ongoing turmoil reflects uncertainty about how the virus will run its course, how public health systems will cope, and how policy tools will be deployed across the globe. Despite such enormous uncertainty, three things have become clear. First, a typical business cycle logic is the wrong framework to use. What we face now is a global natural disaster. To slow the spread of the deadly virus and prevent health systems from collapsing, governments are implementing containment and social distancing policies. But these policies are bringing the global economy to a sudden halt. This economic contraction is necessary. It will also be brutal. Second, rather than trying to stabilise activity, governments are stepping in to avoid lay-offs and relieve cash flow pressures in the private sector. Unaddressed, these could set in motion a lethal credit crunch loop whereby rising defaults make it harder for banks to extend credit, thus accelerating bankruptcies, which leads to more defaults, and so on. This would also destroy long-term production capacity. To this end, public funds will be disbursed to households and companies — although an urgent challenge is to devise mechanisms that ensure their fast delivery. If that is done, this “going direct” approach ensures that when the virus subsides, as it will eventually, there will still be an economy left to jump-start productive activities. 

The details of these policies will differ from country to country. But one thing is clear: the scale of public funds handed to households and to corporates will be unprecedented. Early calculations suggest spending will far exceed that in the global financial crisis. Countries heavily exposed to the virus will probably end up with combined spending and public loan guarantees of up to 20 per cent of gross domestic product in a few months. Third, this is where central banks come in. Monetary policy can help ease market liquidity problems but it cannot be as effective now as in 2008. For one, with interest rates already often at rock bottom levels, the space for conventional and unconventional monetary policies is largely used up.

Even where it isn’t, monetary policy cannot address the root cause of the current crisis. Yet, the magnitude of the challenge is such that fiscal policy cannot shoulder the task alone, either. Left to its own, vast government spending will eventually lead to bond yields rising, making sovereign debt harder to raise and more expensive to finance. This would also risk creating a large public debt-servicing crisis down the road. That is why the policymaking world must evolve to a less simplistic understanding of central bank independence.

 To overcome the perennial inflation challenges of the past century, it was enough to assert that monetary policy decisions should be made independently from government decisions. But to deal with this existential threat to the very foundation of the world’s economic system, a truly independent central bank needs to be confident in its ability to explicitly co-ordinate with other organs of policy, such as the state. What is required now is a co-ordinated approach in which governments disburse needed funds to provide a financial bridge to households and viable corporates. Meanwhile, central banks will be called upon to ensure that interest rates don’t rise in an uncontrolled way amid the largest natural disaster relief programme ever recorded. Part of this will entail large-scale asset purchases by central banks in the bond market. The US Federal Reserve yesterday committed itself to unlimited balance sheet expansion for the foreseeable future. But these purchases must be tied more explicitly to an objective of keeping long-term rates in check. Explicit yield curve control is one way to do this, as the Bank of Japan has shown. The bottom line is this: central banking is once again being reinvented dramatically. It is time to make co-ordination with fiscal counterparts an explicit reality in the face of an unprecedented type of crisis with an unprecedented rise of public debt.

 Jean Boivin, head of the BlackRock Investment Institute, contributed to this article.

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