Is monetary policy alone enough to stimulate economic recovery?

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Xin Min Wang's picture

“…we are in danger of assigning to monetary policy a larger role than it can perform…of asking it to accomplish tasks that it cannot achieve and…of preventing it from making the contribution that it is capable of making.”- Milton Friedman (Friedman, 1968)

As central banks around the world respond vigorously to the current global financial crisis, does Friedman’s caution provide any lessons for us today? In this essay, I argue that the effectiveness of monetary policy depends largely on its suitability for mitigating the type of financial crisis facing individual economies and the exact type of monetary policy used to counter crises. The implementation of any policy, including monetary policy, requires a nuanced understanding of the unique domestic and external circumstances each economy faces and the short and long term dimensions and effects of these policies.

Understanding Financial Crises - What Makes a Financial Crisis Different?

As financial crises are unlike normal recessions, it is crucial to understand the nature of financial crises and their recoveries to determine appropriate policies required to address its effects. Financial crises are typically caused by excessive debt accumulation resulting from credit booms in goods and labour markets, housing booms, and a loss of external competitiveness. As a result, private consumption growth after a crisis tends to be weak as households and firms restore their balance sheets after a period of overleveraging while long term investments suffer due to anemic credit growth. Due to weak private demand, public and external demand is often crucial following a financial crisis (IMF, 2009).

Types of Monetary Policy

  1. Conventional:
    To boost private consumption and investment during a financial crisis, central banks thus adopt expansionary monetary policy by increasing money supply and reducing interest rates, thereby stimulating the real economy through three channels (Ireland, 2008). First, lower interest rates reduce borrowing costs, hence encouraging consumers to spend and businesses to invest. Second, cuts in interest rates increase the profitability of banks and thus their willingness to lend. Third, the resulting currency depreciation from a fall in demand for currency as foreign investors face lower returns increases net exports. Expansionary monetary policies tend to be effective as a study by the International Monetary Fund (IMF, 2009) found that a one-standard deviation reduction in real interest rates beyond that implied by the Taylor rule is associated with a 0.4 per cent increase in growth rates.
  2. Unconventional:
    In financial crises however, central banks often face the so called “zero lower bound problem” where nominal interest rates are at or close to zero. As nominal rates cannot be negative, the usual transmission mechanism of monetary policy breaks down. Furthermore, conventional monetary policy may be insufficient due to the extent of credit spreads and tightening of credit standards (Mishkin, 2009). In such environments, central banks employ various schemes to support credit supply, such as quantitative easing and credit easing, as well as increase credit demand, such as committing to low future rates.
    • Quantitative Easing:
      Quantitative easing refers to a central bank’s purchase of private or public sector securities by expanding its reserve base, which reduces interest rates on the yields of these longer-term securities and thus increases their prices. Financial institutions may also provide additional loans using the extra central bank reserves introduced (Murray, 2009).
    • Credit Easing:
      Central banks can also provide liquidity support to the financial system by lending to financial institutions and providing liquidity directly to credit markets (Bernanke, 2009). Credit easing refers to central bank purchases of private sector assets in segments of financial markets to ease tight credit conditions by promoting greater trade in certain assets through a process of portfolio substitution (Murray, 2009). Liquidity provision by the central bank encourages lending by financial institutions and reduces systemic risk by assuring market participants that cash demands would be met by financial institutions. (Bernanke, 2009).
    • Conditional statements about the future path of policy rates:
      By making a clear conditional commitment to keep the target overnight rate low for an extended period, central banks can influence long term interest rates by increasing the public’s expectations of the time horizon at which short-term rates are held at very low levels, thereby applying downward pressure on longer-term rates and stimulating aggregate demand (Bernanke, 2009).

Evaluating the Effectiveness of Monetary Policy

The effectiveness of monetary policy may be evaluated through the transmission mechanism of monetary policy to real variables involving a two-part process (Penning, Ramayandi & Tang, 2011): first, the transmission from the central bank’s policy rate to financial markets and second, from financial markets to real activity.

For instance, studies have found that the Bank of Japan’s quantitative easing policy between 2001-2006 was effective in the first channel: maintaining financial market stability and an accommodative financial environment, thus reducing uncertainties on future funding and avoiding further weakening of the economy and prices. (Ugai, 2006). However, it was not as effective in the second channel as evidence indicates that the expansion in the money base did not increase broader money aggregates or bank lending substantially as bank lending diminished from the late 1990s to 2006, suggesting that banks hoarded the additional liquidity (Battellino, 2009). This shows that the effectiveness of monetary policy may differ depending on various channels and goals.

Caveats and Limitations of Monetary Policy

The effectiveness of monetary policy depends largely on the perceived independence of central banks and thus their credibility as well as the level of confidence during a crisis. Central banks need to be able to commit and aggregate demand may remain low if consumer and investor confidence is weak. Furthermore, some caveats on monetary policy are necessary. First, loose monetary policy may cause future liquidity crises by creating moral hazard, thereby encouraging more risky and less liquid investments (Nikolaou, 2009). Second, time lags in the transmission mechanism may result in late exit from loose monetary policy, leading to future macroeconomic imbalances.

Third, monetary policy must not be viewed as a short term panacea for required deeper structural adjustments to economies. Policies aiming to mitigate the effects of any crisis must address the specific roots of the crisis. For instance, the central banker of the Bank of Japan has argued that monetary policy alone cannot end deflation in Japan as it is caused by a lack of demand and thus requires measures to restructure and expand the real economy (Tabuchi, 2012). An emphasis on short term measures of employment and GDP growth figures through monetary means may thus detract from deeper and longer term structural issues, such as a mismatch of skills or a debt overhang (Mishkin, 2009).

Other Policy Measures

  1. Fiscal Stimulus
    While monetary policy does play an important role in mitigating recessions, it is often insufficient to boost growth as its effectiveness is often undermined in the aftermath of a financial crisis due to financial sector stresses (IMF, 2009). A holistic policy package including fiscal stimulus is thus likely more effective in mitigating financial crises as fiscal policy provides a more direct means of stimulating the economy. Indeed, it has been estimated that under coordinated fiscal and monetary policies, every dollar spent on government investment can increase GDP by about $3, while every dollar of targeted transfers can increase GDP by about $1 (Freedman, Kumhof, Laxton, & Lee, 2009). However, given that financial crises are often triggered by debt, it is important that public debt sustainability remains preserved over the medium term.
  2. Financial Stabilisation Policy
    While monetary and fiscal policies are powerful measures to restore growth, experiences from the Great Depression and previous recessions have shown the effectiveness of monetary and fiscal policies is greatly reduced without the implementation of prompt and well-targeted financial policies (IMF, 2009). It is thus important for central banks to provide greater certainty about the long-term solvency of financial institutions by forcing credible and coordinated loan loss recognition and by providing public support to viable financial institutions. Insolvent banks should also be resolved and public agencies set up to dispose of bad debts acquired by the government. Furthermore, immediate policies should be in line with long-run goals for restructuring financial sectors. (Decressin&Laxton,2009).

In conclusion, Friedman’s cautionary statement still holds true today; monetary policy alone is rarely enough to mitigate the effects of a financial crisis. Rather, policies need to be coordinated at all fronts to increase their effectiveness in restoring growth. It is crucial that these policies address the specific root causes of the crisis and are tailored toward the unique individual crisis as well as domestic and external economic conditions each country is in. History has shown that recoveries from downturns caused by financial crises are often slower due to weak domestic demand and tight credit conditions (Yellen, 2009). Furthermore, as financial crises are a result of deeper structural issues such as a loss of competitiveness, structural adjustments are often required. Hence, while monetary policy plays an important role in promoting short-term growth, it should not detract from longer term reform required to foster higher trend rates of growth.