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Bank of England Economics viewpoint
Financial crisis fixes leave policymakers short of ammo for next recession
Central banks would have liked by now to have returned monetary policy to a more normal setting so they have wriggle room when things turn nasty
A Chinese investor brokerage house in Hangzhou city, east China’s Zhejiang province.
A Chinese investor brokerage house in Hangzhou city, east China’s Zhejiang province. Photograph: Imaginechina/Corbis
Larry Elliott Economics editor
Sunday 31 May 2015 12.01 BST Last modified on Wednesday 3 June 2015 10.55 BST
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For 75 months it has been the same story. The nine members of the Bank of England’s monetary policy committee gather, consider all the latest evidence and decide that official interest rates should remain at 0.5%.
Interest rates are at rock-bottom levels pretty much everywhere in the developed world and the moment for raising them continues to be pushed back. But central banks have not just relied on interest rates. They have also been active in the financial markets, exchanging bonds and other assets for cash. This process, known as quantitative easing, has increased the supply of money and driven down long-term interest rates.
For a while, finance ministries also did their part. During the worst of the crisis in 2008-09, they cut taxes and increased spending in order to boost economic activity. In Britain, the result of running much bigger annual budget deficits led to a doubling of the national debt as a share of economic output from 40% to 80%.
The stimulus worked, but only up to a point. The US, for example, has a history of bouncing back from recessions but growth has averaged only 2% a year in the six years since the economy bottomed out. Put another way, America’s most severe post-war recession has been followed by the weakest recovery. The eurozone is on course to post growth of around 1.5% this year – and that’s considered good. By recent standards, it is.
After all this time and all that effort, central banks would also not have expected inflation to be so low. Yet in the UK, the cost of living as measured by the consumer prices index has gone negative for the first time in half a century. Earnings are increasing at half their pre-crisis rate. So, seen from the perspective of both growth and inflation, there is good reason for central banks to be wary of tightening policy.
There are, though, other reasons why central banks might want to raise interest rates or to start unwinding QE. One is that too much stimulus for too long, particularly if it is of the unconventional sort, can have unintended consequences. Interest rates at close to zero plus oodles of cheap credit have encouraged a search for yield, the hunt for investments that provide a decent return. This, inevitably, means riskier bets, as it did in the years leading up to the financial crisis. One key lesson of that period is that crises can erupt even when inflation is low.
The second reason central banks would have liked by now to have returned policy to a more normal setting is that they have little wriggle room if things turn nasty again. Official forecasts always assume that economies will enjoy reasonable levels of growth with modest levels of inflation. But, regular as clockwork, stuff happens. Recessions occur, often suddenly, and for all sorts of reasons. In those circumstances, central bankers and finance ministers need firepower. Ideally, they want to be in a position to slash interest rates, run bigger budget deficits and, if necessary, resort to the more unconventional instruments such as QE.
This firepower is currently lacking. On average, the US Federal Reserve has cut its main interest rate by five percentage points in each of the recessions since the 1970s. That’s impossible with interest rates so close to zero. Increasing QE runs the risk of further inflating share prices, which are already high. Governments can always spend and borrow more in times of trouble, but ideally would like to have built up a war chest first. In most countries, this has proved impossible.
Given time, central banks and finance ministries will replenish their ammunition. Interest rates will gradually be raised. Growth will lead to higher tax returns and lower spending on welfare. It would be greatly beneficial were the global economy to be set fair for a repeat of what Lord Mervyn King described as the Nice decade (non-inflationary, continual expansion).
How to get the economy working for us
But this can’t be guaranteed. Imagine that Greece defaults on its debts and returns to the drachma, with knock-on effects on the eurozone and the wider global economy. Or that the recent plunge in shares on the Shanghai stock exchange are the portent of a hard landing in China. Or that the recent rise in bond yields (the interest rate paid) is a sign of a bubble about to burst.
Stephen King, chief economist at HSBC, calls this the world’s “Titanic problem”, by which he means there are plenty of icebergs but no lifeboats. So what are the options for policy makers? King lists six. Firstly, they could try to avoid hitting one of the icebergs. They tighten supervision and regulation of the financial sector, force banks to hold more capital, keep a wary eye on asset prices. But the next crisis might not originate from the banks. It might stem from the insurance industry, struggling to cope with ultra-low interest rates or from over-leveraged hedge funds.
Secondly, they could do more QE. Given the limited success of QE so far, coupled with the risk of dangerous side-effects, this looks unlikely to be all that effective. Thirdly, they could decide to ignore the fact that inflation is well below the targets set for central banks and decide that the threat of asset-price bubbles warrants higher interest rates. This might trigger the recession policy makers are seeking to avoid.
Fourthly, they could decide to turn to fiscal policy – tax cuts and higher public spending – on the grounds that there was little scope to boost the economy through interest rates and QE. But as King notes, this is only possible if governments are “willing and able to tolerate deficits and debt levels far higher than seen in the peacetime past”.
Fifthly, they could resort to “helicopter drops” of money, which is where a central bank creates money and the finance ministry hands it out in the form of tax cuts or higher public spending. There are two downsides with this option. One is that in some countries, including the UK, the increased spending would result in higher imports and a balance of payments crisis. The second is the risk of hyper-inflation.
King says his sixth and final option would be to raise retirement ages. There is a global glut of savings, he says, caused by people salting money away for their old age. Working longer would mean people spending more, raising growth rates. This would boost tax revenues and allow interest rates to rise. Governments would once again have some ammo, but at the expense of political unpopularity.
King says that if history is any guide, we are probably closer to the next US recession than the last one. Back in 2008-09, there were lifeboats even if there weren’t enough of them. Next time, if there is a next time, the losses would be worse.