Sebastian Mackay. Fund manager, Multi Asset
The coronavirus pandemic 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.
Before the current crisis, 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.
Central banks and governments are acting together
The devastating blow of coronavirus has forced policymakers to think radically about how to keep households and companies afloat while lockdowns cause most economic activity to halt abruptly. In the developed world, governments have 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, production of medical equipment 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 and, in the case of the Bank of England, also providing direct finance through the short-term ways and means facility. In some cases, central banks have also adopted yield curve control and corporate bond (including high yield in the US) 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. Apart from select areas, demand for goods and services has collapsed resulting in an intensification of deflationary forces that were already present. In addition, the expansion of central banks balance sheet aims to plug the hole left by a dramatic drop in credit demand.
Are these changes permanent?
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 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. In a crisis situation such as the current pandemic, economies are clearly a long way from full employment but, even outside of crises, there is evidence that most economies do not naturally revert to full employment.
There is also evidence that governments’ reluctance to run deficits results in the build-up of debt in the private sector, which in turn leads to instability.
Problems for emerging markets and the euro area
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. Emerging economies’ limited scope to use their central bank to finance fiscal deficits has led to a spike in the number of requests for help from the IMF in recent months.
One neat solution would be to increase the allocation of Special Drawing Rights (claims on the currencies of IMF members) to emerging economies. This would effectively give emerging economies more scope to repay foreign currency debt and protect their own currencies.
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 European Central Bank will simply print whatever currency is necessary to meet countries’ deficits.
Moreover, the inability of less competitive economies to devalue forces unnecessarily economic adjustments that endanger the union. Northern Europe’s reluctance to consider jointly issued debt in response to the pandemic will also increase strains on the currency area.
If a coronavirus vaccine is found, the global economy should start to return to normal but the path to re-separating fiscal and monetary policy could be complex.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.