Is monetary policy alone enough to stimulate economic recovery?

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Sean Freeman's picture

One of the central principals of central banks is to maintain stable and low inflation. However, in a national or global economic crisis, economic stimulus may become the main priority of governments and electorates. How effective or ineffective are changes of monetary policy by a central bank in the face of a financial crisis?

Monetary Policy in Crisis Situations

Monetary policy is a powerful and appropriate tool for reviving an economy, but it alone is limited in what it can achieve.  During a normal business cycle, or with minor shocks to the economic system, gradual shifts in the interest rate would be sufficient to maintain a steady economic outlook.  However, with crises such as the global recession that began in 2008, and stubbornly persists even to today, a greater effort is required.  To reach a sustained recovery it is required of central bankers and politicians alike to devise a comprehensive plan that includes monetary and fiscal planning, government intervention and contributions from the private sector.

This debate has been held to varying degrees throughout modern history most notably in the early part of the twentieth century.  The famous discourse between John Maynard Keynes and Fredrich von Hayek would solidify schools of thought for decades to come.  Disciples from each school of thought will debate the degree to which policies should be implemented and the impact they will have.  Yet in devising solutions for recovery both disciplines will agree it is critical to make the distinction between the immediate crises and longer term planning.  Most monetary planning is devised for targeting inflation in the long run.  Its mechanism are not designed for or prepared to combat short-term market disruptions, and certainly not acute crises of which events can be measured in days not years.  Yet the United States' economy like most other developed economies has the ability to absorb a higher rate of inflation while other short-term needs are met. 

The scope of monetary policy;

It was not monetary policy alone that led to the crises of 2008, and it is certainly too limited in scope to be a sufficient solution on its own.  In understanding the crux of the matter one must firstly remember the remarkable nature of this most recent crisis.  Not even the Great Depression, at its most devastating period, provided an accurate blueprint of how to resolve the crisis in today's global economy.  Economist seemed dumbstruck as most economic rules they learned went right out the window.  The house was on fire, as capitalism itself was called into question.  And when the roof of one's home is burning no one is concerned with the long-term kitchen remodeling.  The pressing needs take precedence.  A short-term stimulus is needed to douse the flames and avoid catastrophe. 

Government intervention

 The role of government intervention into the economy may be demonized by conservative critics on the right, but in dealing with crises government has an indispensable role to play.  Providing a much needed "shot in the arm" economic stimulus is essential to bring about a recovery.  The Bush administration in 2008 and the Obama administration in 2009 implemented multiple stimulus packages totaling nearly US$1 trillion.1  This was done with bi-partisan support from law makers in what is by and large considered a critical move in averting disaster. 

The disbursement of these funds cannot simply flood the market but rather needs to be strategic and implemented with precision in order to receive the greatest multiplier effect from its disbursement.  The best example of this is with federal monies specifically apportioned for state infrastructure projects.  Many of the roads and bridges, power lines and ports are ailing around the United States.  By funneling stimulus funds directly into projects such as these it immediately increases employment, and creates a boon for the local economy that would not have otherwise existed.  Additionally, direct assistance targeted toward essential industries like the automotive industry is essential in order to avoid a ripple effect throughout the country. 

These problems were more acute in nature and required swift and decisive action on the part of government.  Monetary policy would be incapable of producing such effects alone.   

Governments must next take steps to give assurances to the private sector and general public.  Similar to monetary policy, governmental policies are not a panacea in and of themselves if the public lacks confidence in the system.  Weary households will spurn the advise of the government and save a higher percentage of income in tough times.  Businesses, uncertain of the economic climate, will not expand, cease to make investments and decrease staffs.  This is the other side of the equation.  A basic reading of economics dictates there must be a buyer for every seller.  Over 70% of the United States economy is based on domestic consumption.2  The best way for a recovery to take hold is if people spend a higher percentage of disposable income.  This means eating in restaurants, taking vacations, trips to the mall and the movie theater.  With these actions the gears of the economy will be lubricated, the engine will rev faster and growth will occur once more. 

Politics

Public confidence only arises from leadership that can act responsibly and set aside ideological differences to put out the fire.  Congressional infighting only produces gridlock and prolongs the time and severity of a recession.  Legislatures have the ability to greatly turn the tide during a crises with a few very straightforward actions.  If relief for those unfortunate enough to be unemployed due to an economic down turn were not called into question by politicians, much of the fears and anxiety of the general populace with be ameliorated.  The speculative nature of securities trading must also be scrutinized, and quantitative and hedge funds must be closely regulated.  These factors have done a great deal to cause the recession, and much of their tactics for hedging against the economic growth can do much to derail and undermine the fragile recovery process.  Critical to this process is that legislation be put to congress in a simple up or down vote, and not watered down and negotiated to the point where it has no real effect.

Banking sector

The banking and financial sector has an independent role to play as well.  One of the factors that prolonged the recovery from the 2008 crisis is that banks, which received federal bailouts, were not injecting that capital into the financial system.  Actions like these will severely undermine the recovery process.  The Federal Reserve can slash interest rates close to zero and allow for greater inflation in an attempt to simulate growth, but if capital is being cut off at a certain point the health of the aggregate economy will be in jeopardy. 

If banks do not award loans voluntarily they must be forced to.  It should be written into the contract that any bank receiving federal funds must in turn distribute this with normal banking activity in the form of granting loans and mortgages.  Governments must also incentivize other banks to continue banking activity, and if need be, circumvent the entire process by providing loans directly to consumers via credit unions and other government instruments.

Conclusion

Lowering the deficit and the overall national debt are critical components for the long-term health of the economy.  A stable monetary policy has a central role to play in setting the parameters of the economy to spur on growth an alleviate these long-term pressures.  These factors, however, must take a backseat to the more immediate threats of a crisis and its recovery.  Economic wounds must be cauterized with stimulus and responsible government intervention before the long-term healing can begin.  A government must exhaust all its resources in order to rebuild a robust economy.

References: 
  1. CBS News. "Bush agrees to Obama bailout request" CBS News June 2009. http://www.cbsnews.com/stories/2009/01/12/politics/main4714609.shtml
  2. Reuters.  "Slight increase last month in spending by consumers" New York Times December, 2011.  http://www.nytimes.com/2011/12/24/business/economy/us- consumer-spending-rise-is-slim.html?scp=10&sq=consumer%20spending&st=Search
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