Policymakers rethink

Before the coronavirus pandemic, the scope for traditional policy to respond to the next recession was limited. Interest rates in much of the developed world were close to zero, budget constraints left little room for fiscal expansion and central bank balance sheets had already expanded significantly.

The devastating blow of coronavirus forced policymakers to think radically about how to keep households and companies afloat while lockdowns caused most economic activity to halt abruptly. In the developed world, governments announced planned fiscal deficits of as much as 20% of GDP to finance unemployment benefits, wage replacement for furloughed workers, support for businesses forced to shut, tax credits and so on. At the same time, central banks are playing a key role, effectively financing fiscal deficits by buying government bonds in the secondary market. In some cases, central banks have also adopted yield curve control and corporate bond (including high yield) purchases.

It’s difficult to avoid the conclusion that Modern Monetary Theory (MMT) was right – currency issuing governments do not face the same budget constraints as households. It’s always possible for the central bank to issue currency to finance government deficits and the budget constraints used previously to justify austerity were false. Of course, we don’t yet know the consequences of monetary financing of deficits but in the current context it’s important to recognise that the central bank is stepping in to fill a void. The pandemic is a real economy crisis and it makes sense that the policy response has been to address broad money growth, utilising the banks to channel funds to households and companies to supplement lost income and earnings. It is precisely because velocity of money circulation has fallen that the policy response has been to boost to broad money growth, in an effort to put a floor under nominal GDP.

Economies are now opening up again and growth is recovering but will policymakers simply revert to the old orthodoxy that fiscal and monetary policy should be separate and governments must spend only what can be raised by taxation or borrowed? It will be difficult for governments to argue, for example, that the health service must remain underfunded because the money simply isn’t there, when we’ve just seen that that it is straightforward for central banks to ‘write the government’s cheques’. As long as monetary financed spending doesn’t push the economy beyond full employment, inflation will remain contained. Even outside of crises, there is evidence that most economies do not naturally revert to full employment and that governments’ reluctance to run deficits results in the build-up of debt in the private sector, which in turn leads to instability.

There are two groups of countries for whom monetary financing of fiscal deficits is problematic – emerging market countries with significant foreign currency debt and members of the euro area. For emerging economies, the primary issue is that they can’t print foreign currency to redeem their debts and a secondary problem is the increase in the burden of foreign currency debt in the case of devaluation. Despite these constraints and a spike in requests for help from the IMF, many emerging economies have launched significant Quantitative Easing (QE) programs and in some cases even bought government bonds in the primary market. It is too early to judge how successful these policies will be but significant devaluations of emerging market currencies this year does ring alarm bells.

In the euro area, the mismatch between monetary policy determined for the whole region and fiscal policy set at the national level undermines faith that the ECB will simply print whatever currency is necessary to meet countries’ deficits. Moreover, the inability of less competitive economies to devalue forces painful economic adjustments that endanger the union. QE from the ECB and the Franco- German proposal for a EU Recovery Fund, funded in part by EC issued bonds, are steps in the right direction but the area remains some distance from the model of fully unified monetary and fiscal policy needed for central bank financing of deficits.

The crisis has forced policymakers to consider a degree of cooperation between central banks, government and financial markets previously considered dangerous. The Rubicon has been crossed and these are now important components of the recession response toolkit.

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