By Larry Hatheway
EITAN ABRAMOVICH/AFP via Getty Images
ZURICH, Switzerland (Project Syndicate — Recent jumps in equity prices and bond yields suggest that recession fears are receding. But the global economic expansion cannot last forever, and when the next recession comes, central banks may not be adequately prepared to respond. Enhancing central-bank credibility to bolster the effectiveness of monetary policy is thus an urgent priority.
Before the 2008 financial crisis, central bankers could rely on slashing interest rates to spur consumption, investment, and employment. But that playbook no longer works as well as it once did.
One reason is elevated uncertainty, owing to globalization, societal aging, changing consumer preferences, growing income and wealth inequality, rising health-care costs, rapid technological change, and other factors.
The old central-bank playbook of slashing interest rates to spur consumption, investment, and employment has become less effective since the 2008 financial crisis. Yet without effective tools and the public’s confidence, central banks will be unable to rise to the occasion when the next recession arrives.
Even in the absence of recession, for many households and businesses, the future seems daunting and unpredictable.
This uncertainty will exacerbate the downturn when it comes. When uncertainty spikes, low or even negative real (inflation-adjusted) interest rates may not induce higher spending. Rather, savings may rise and investment may falter even as interest rates plunge. If governments are unwilling or unable to boost demand with fiscal policy, the result will be a prolonged and deep economic slump.
Few would doubt that monetary policy should be eased in such circumstances. In theory, central banks have extraordinary means to respond, through negative interest rates, asset purchases, “forward guidance,” and the like.
Yet, in practice, central banks face tight constraints, which means that their response to the next recession may prove insufficient.
Broadly, these constraints fall into two categories: laws or established policies that define what monetary policy can do; and political and institutional limits that hem in central banks’ decision-making.
The legal limitations vary according to the political and institutional environment and history of a central bank’s jurisdiction. In conducting open market operations, for example, the Federal Reserve may purchase only debt securities issued or guaranteed by the federal government. In contrast, the Bank of Japan may purchase private-sector securities such as equities or corporate bonds, giving it potentially greater latitude to expand its balance sheet and stimulate corporate finance.
Such differences could matter in the event of a severe slump that requires extraordinary measures.
To take an extreme example, the Fed cannot unilaterally create “helicopter money” — a metaphor invoked by Milton Friedman to describe how a central bank might distribute cash directly to individuals in order to stimulate consumption.
To create cash (a central-bank liability), the Fed must purchase an asset. Yet because private-sector IOUs are not eligible assets, the Fed cannot distribute cash directly to the bank accounts of ordinary Americans (nor could it drop $20 bills from the sky, even if it had the helicopters).