Is monetary policy alone enough to stimulate economic recovery?

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Romain Su's picture

Monetary policy, alongside budgetary policy, is usually considered one of the two tools at the disposal of public authorities when they need to smooth the inevitable fluctuations characteristic of capitalist, boom and bust economies. Through the setting of interest rates, they can indeed influence the “price of money” in order to regulate how much credit commercial banks can pump into the economy. When credit costs are low, households and enterprises normally have an incentive to borrow and consume or invest, while savings are less profitable. On the contrary, higher interest rates make savings relatively more attractive than loans, with a negative impact on aggregate demand.

 This conceptual framework, mainly laid down by John M. Keynes in the 1930s, has never since then been seriously challenged and is still used today by economic international organizations as well as national administrations. However, the effectiveness of monetary policy on delivering recovery in times of crisis has been called into question in the 1970s when traditional, Keynesian economic policy instruments failed to overcome the recession triggered by tremendous oil price surges. This new school of thought called monetarism developed upon the older idea of quantity theory of money to assert that monetary policy is in the long run neutral regarding “real” growth. After a few years when additional credit inflows might be able to stimulate demand, economic agents would quickly realize they have been victims of a “money illusion” and the subsequent readjustment of prices and wages would drive the economy back to its initial state with higher inflation.

Paradoxically, while this view has essentially been advocated by American scholars such as Milton Friedman, it has found its most fertile field of application in Europe, first in Germany then at the eurozone level. In a striking contrast with its American and British counterparts, which are mandated to pursue on an equal footing both policy objectives of growth and price stability, the European Central Bank must according to the Treaties give precedence to the latter. This focus on the fight against inflation, inherited after the Bundesbank, does not in theory leave the ECB a very large room for manœuvre in the realm of economic, anti-cyclical policies since the spectre of inflation is never far away.

The relative passiveness of the ECB was at first confirmed when the financial crisis, originally coming from the United States, hit Europe in 2008 as a consequence of Lehman Brothers' bankruptcy. Contrary to the Bank of England and the Federal Reserve, which were quick to cut interest rates close to 0% and to launch quantitative easing programmes in order to avoid a credit crunch, the ECB has in fact never decreased the interest rate on main refinancing operations below 1%. It nevertheless undertook to tackle the crisis of confidence between commercial banks by “non-standard” measures such as the extension of the list of assets eligible as collateral or the return to a fixed rate tender procedure for open market operations1. As a result, Western economies have been rescued from a liquidity shortage scenario which would have not only pushed more banks to meet the same fate as Lehman Brothers, but also disrupted financing channels.

Even though it is not yet tantamount to an economic recovery, this achievement deserves mention since growth can hardly be imaginable without a sound and effective financing system. Indeed, despite heavy criticism on the behalf of the general public who often accuses the finance industry of being unproductive and harmful to the “real” economy, the “real” economy cannot in reality thrive without being supported by adequate and reliable financing channels. The reason is very simple: growth partly comes from investment, which requires today's capital to make tomorrow's profits. Finance fills this time gap between current needs and future expectations by transforming savings into loans or stocks, thus allowing businesses to launch new projects and possibly to generate growth and jobs. Without finance, entrepreneurs would have to save up enough money on their own until they could eventually open their businesses, a task virtually impossible in the case of capital-intensive industries. Up to this point, monetary policy has at least succeeded in preserving one of the necessary conditions for an economic recovery to occur.

 As essential as it is, this condition is nevertheless not sufficient. Investment depends for sure on the cost of capital, i.e. indirectly on central banks' interest rates, but it is not likely to be triggered if demand perspectives look gloomy. Lower interest rates may render savings less profitable, but consumers will certainly not purchase more if they expect taxes to rise in order to fix the budget deficit. Even commercial banks may not be willing to distribute more loans despite the mountains of cheap money provided by central banks if they consider the economic outlook to be so dark that they are convinced they will not be reimbursed. As a matter of fact, growth is closely connected with the idea of confidence, and monetary policy is on its own powerless to restore trust in the future.

 Interestingly enough, monetary policy has over the past two years been forced to deal with a problem that had been for a long time excluded from its field of competence: public finances. In accordance with the canon of monetarism, monetary policy had to be taken off the hands of political authorities and be entrusted instead to independent central banks. Thus monetary policy would be pursued in line with its only reachable objective in the long run, i.e. price stability, and would not be subject to interferences that would deviate it from this mission and eventually generate inflation. Among these interferences is the ability of a central bank to buy public debt of a given country, virtually giving its government access to an unlimited source of financing. The practice, almost abandoned in most developed countries after the 1970s, has recently come back on the front stage, even though it is not now always carried out as such.

This return has obviously been made necessary by the so-called sovereign debt crisis, which affects both EU countries and the United States despite less significant effects in the latter. After one decade, when not more, of relative indifference to the public debt issue, growing mistrust around the rating agencies and unrealistic deposit guarantees provided by certain governments acted as a wake up call for investors previously confident in Treasury bonds: it suddenly appeared that states were also vulnerable to the risk of bankruptcy.

 The downgrading of Greek government debt in April 2010 showed at the same time that sharing a common currency does not flatten solvency level: Greek bonds could no longer boast the same quality as their German equivalents. On this fire front, the ECB was more prompt to react and only a few days later, it launched the Securities Markets Programme2. Though this instrument does not allow the ECB to directly purchase government debt on primary markets — a hypothesis ruled out by the “no-bail-out clause” of the Treaties —, it has encouraged commercial banks to do so. Notwithstanding, one had to wait until January 2012 to notice a relatively lasting moment of calm, after the ECB launched an exceptional operation worth almost €500 billion3. With this money, banks could buy sovereign debt and contribute to reverse the upward pressure on interest rates.

True enough, lower interest rates on government bonds mechanically decrease the burden of debt servicing on public finances. One could however draw an analogous conclusion to what has been said about the financial system. If a balanced budget offers in theory the double advantage of not sucking away savings at the expense of private investments and of favouring consumption — the reciprocal of the Ricardian equivalence —, this virtuous circle can be triggered only in a healthy economy. Monetary policy, no more than rigorous budgetary policy, are able to transform productive structures inadequate for international competition into modern, knowledge-based economies, nor can they make up for thirty years of antiredistributive fiscal decisions that caused, to a large extent, the private debt boom and then the current crisis. Thinking that this is just another cyclical bust phase which can be smoothened by traditional economic policy instruments would be an erroneous diagnosis. What we are experiencing now is a failure of a model, and only structural changes, if not change of the model itself, has a chance to work out.

  1. ECB, The ECB’s response to the financial crisis, ECB Monthly Bulletin, October 2010.
  2. Bruegel, Behind the ECB's Wall of Money, Benedicta Marzinotto, 19th January 2012.
  3. Ibid.