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?
I assert that monetary policy is not enough to stimulate economic recovery. While traditional monetary policy tools are effective during less pronounced recessions, during times of crisis these tools are ineffective alone. Monetary policy tools would be far more effective if implemented in concert with Keynesian-inspired periods of policy-led “super investing”.
There are several major categories of tools that central banks’ employ to effect change in money supply: altering the required reserve ratio, engaging in open market operations, engaging in FX market intervention, and altering the discount rate. In a recession, central banks increase money supply in order to lower interest rates and encourage borrowing, hence stimulating economic activity. Do these central banking tools accomplish this? Under normal circumstances, they do. Lowering the reserving ratio increases the amount of excess reserves that banks can lend out. Engaging in open market operations is effective as well; when a central bank buys securities, it injects money into the economy, likewise increasing money supply. FX intervention is equally effective, as a county’s monetary base is expanded when its central bank buys foreign currencies. Lastly, lowering the discount rate entices banks to borrow from the central bank, also expanding a nation’s monetary base.
While these tools are effective, they are not equally effective. Discount rate lowering is the weakest of tools: when customers are not borrowing from banks, then banks, in turn, have no reason to borrow from the central bank – no matter how low the rate is. Rather, open market operations have become the preferred tool, as they are a more direct way of increasing money supply (Marthinsen 251). When a central bank buys securities, it injects money into the economy. It injects the purchase amount, which is compounded by the money multiplier.
I describe a case in point in which open market operations have been more effective than rate adjustment tools. During the global financial crisis beginning in 2008, when the Federal Reserve engaged in Quantitative Easing by making asset purchases under “TARP” and mortgage-backed purchases under “Maiden Lane” accounts, this form of open market operations was a more effective tool than the European Central Bank’s main refinancing operation (MRO) rate lowering, and long-term refinancing operation (LTRO) introduction. While not a discount rate tool, the liquidity enhancing MRO/LTRO ECB tools were similar to lowering the discount rate, since they were designed to facilitate and lower the cost of bank borrowing from the central bank. In Gunnar Trumbull’s Harvard Business School case study entitled “The Euro in Crisis”, the author stated that, “The LTROs were meant to have two effects: lowering the rates on medium-term assets and signaling to banks that the ECB was committed to liquidity support over the longer term.” Quantitative Easing (QE), conversely, was a form of open market operations. While the Fed’s QE had the important added benefit of removing problematic assets from U.S. banks’ balance sheets, it also increased the U.S. money supply very directly. MRO and LRTO tools, were more indirect. When GDP is contracting and there is little lending going on in an economy, rate-lowering tools are indirect and weak. It seems the ECB later acknowledged this by adopting its own QE tools in 2009, when the ECB announced that it would make commercial covered bond purchases. Apparently, not all money supply-altering central banking tools are equally effective.
Further, all central banking tools would be made more effective if implemented in concert with incentives that modify a corporate investment trends. In revisiting the question of why discount rate lowering is not the most effective central banking tool, banks have no need to borrow from the central bank when consumer are not borrowing from banks. This is natural: during times of crisis, when a country’s corporations are uncertain about future business prospects, there is no borrowing rate at which they will invest, as long as that uncertainty exists. This uncertainty, together with shrinking consumption, in manifested in the form of a contracting GDP that is an inevitable side effect of a financial crisis. The question then becomes, how do we stimulate GDP? A Keynesian would argue that this catalyst should come from an increase in deficit-fuelled government spending. I believe there is another answer, that corporate spending should be that catalyst. Corporations should be encouraged to engage in bursts of private “super-investing”, fuelled by policies such as implementing intervals of temporary elimination of repatriation taxes with the caveat that the repatriated amount must be immediately invested. While the U.S. has implemented corporate repatriation tax holidays in the past, they were not tied to mandatory investment requirements. Only when the repatriation amount is directly used for investment will this strategy be effective.
While the tools of monetary policy are generally effective, some are more effective than others. Central banks would do well to focus on tools that directly increase money supply, such as engaging in open market operations and FX market intervention, during times of crises. However, crises can be so pronounced that no increase in money supply, no decrease in rates will spur consumption. The Keynesian model of government-led deficit-fuelled growth is one that needs to be replaced with a model where the private sector provides the catalyst behind GDP growth, the necessary spark that reverses GDP contractions that are typical of financial crises. Governments must adopt policies that fuel corporate “super-investing”, such as repatriation tax breaks, hand in hand with attempts to increase money supply during periods of crisis. By complementing the tools of monetary policy with investment-conducive tax structures, those manoeuvres will have a better chance of success.
- Marthinsen, John E. Managing in a Global Economy: Demystifying International Macroeconomics. Thomson Learning, Inc., 2008. Print.
- Trumbull, Gunnar, Dante Roscini and Diane Choi. “The Euro in Crisis: Decision Time at the European Central Bank.” Harvard Business School Publishing (2011): 3-5. Print.
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