Fiscal and monetary policy can do little without some return of trust
How bad is the current crisis? Bad enough for Barack Obama's new US Administration to reach a deal with Congress on an $827 billion stimulus package, worth almost six per cent of GDP if delivered in a single year. Bad enough for the Bank of England to...
How bad is the current crisis? Bad enough for Barack Obama's new US Administration to reach a deal with Congress on an $827 billion stimulus package, worth almost six per cent of GDP if delivered in a single year. Bad enough for the Bank of England to have lowered its key interest rate to just one per cent. And bad enough for China, to indicate that it may have to offer even more emergency economic support despite already having provided a massive shot into the arm of the domestic economy late last year.
It would be nice to believe that these measures will take the world economy smoothly out of the current economic mess. This optimistic view of economic life derives from two related sources. The first is what has become known as the "Greenspan put", the idea that, whatever awful difficulties descend upon the world economy, policymakers stand ready to clear up the mess. The second comes from Milton Friedman's interpretation of the 1930s. He argued that the Depression need not have been anything like so bad had the Federal Reserve loosened monetary policy promptly and aggressively.
But are these views entirely right? The evidence from the last 18 months is disheartening. Policymakers have used much more ammunition than anyone could have predicted back in the first half of 2007 when banks had plenty of funds and investors were falling over each other to buy mortgage-backed securities. Since then, the financial system has ground to a halt. Yes, interest rates have come down and, recently, interest rate spreads have narrowed. The price of credit, though, is not the central problem. The credit crunch is ultimately a story about the quantity of credit, chiefly because banks have lost vast sources of funds with which to support lending as a result of the collapse in securitisation.
Although the heavy guns of economic policy have now been fired on numerous occasions, economic performance around the world has been dismal, culminating in a frenzy of disastrously weak numbers over the last couple of months. In December, manufacturing output in the US and the UK was down around 10 per cent year-on-year. German industrial production was down 12 per cent over the same period. As for Japan, output was down 20 per cent year-on-year.
So far, there is little evidence that the policy stimulus is working well. There are two big problems. First, what is the right amount of policy stimulus? The answer depends on the scale of the expected problem. Given that policy changes have an impact on economic activity only with a lag, policymakers need to gauge their actions according to projections of where the economy might be heading.
A year ago, no one was able to forecast the extent to which the global economy was about to fall off a cliff, so policymakers were unable to come up with a series of stimulus plans back then which would have carried any credibility either politically or in the world's media. Making a judgment on likely economic outcomes associated with the latest stimulus measures requires a huge leap of faith with regard to the path for the world economy in the absence of these measures. Knowing, for example, that a stimulus package will add, say, one per cent to the level of GDP tells you very little about the actual growth rate.
Second, the stimulus needs to be credible. As interest rates sink to zero, as central banks buy up stacks of financial assets and as governments run bigger and bigger budget deficits, policymakers need to offer cogent explanations to the public of why these policies will actually work. Quantitative easing becomes the default monetary policy only once interest rates have dropped to zero. Given that quantitative easing is typically not used in normal economic circumstances, it comes across very much as a second best option. The public, rightly, will wonder whether it will really work.
The "something must be done" approach to economic policy is all very well, but the overriding impression at the moment is that policymakers are not sure what is to be done as both the scale of the economic problem turns out to be bigger than expected and the conventional ammunition runs dry. Policies are increasingly being adopted through force of circumstance and the political desire for action, not as a result of a cold analysis of what is likely to solve the current crisis. After all, many of the policies now being adopted were precisely those which met with total rejection in the 1980s and 1990s.
The underlying problem faced by policymakers is a massive breakdown of trust in the functioning of the financial system, a difficulty which cannot be fixed overnight.
Conventional economic policies typically cast their spell on the economy via banks and other financial intermediaries. The case for unconventional policies ultimately rests on the idea that the financial system has to be bypassed in an effort to "protect" the real economy from the dangers of a Depression-style economic meltdown. While there is nothing necessarily wrong with this approach, the best that can be hoped for from these policies is a cushioning of the downside risks. We are now in a world of damage limitation, not a world in which recovery lies just around the corner.
• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
It would be nice to believe that these measures will take the world economy smoothly out of the current economic mess. This optimistic view of economic life derives from two related sources. The first is what has become known as the "Greenspan put", the idea that, whatever awful difficulties descend upon the world economy, policymakers stand ready to clear up the mess. The second comes from Milton Friedman's interpretation of the 1930s. He argued that the Depression need not have been anything like so bad had the Federal Reserve loosened monetary policy promptly and aggressively.
But are these views entirely right? The evidence from the last 18 months is disheartening. Policymakers have used much more ammunition than anyone could have predicted back in the first half of 2007 when banks had plenty of funds and investors were falling over each other to buy mortgage-backed securities. Since then, the financial system has ground to a halt. Yes, interest rates have come down and, recently, interest rate spreads have narrowed. The price of credit, though, is not the central problem. The credit crunch is ultimately a story about the quantity of credit, chiefly because banks have lost vast sources of funds with which to support lending as a result of the collapse in securitisation.
Although the heavy guns of economic policy have now been fired on numerous occasions, economic performance around the world has been dismal, culminating in a frenzy of disastrously weak numbers over the last couple of months. In December, manufacturing output in the US and the UK was down around 10 per cent year-on-year. German industrial production was down 12 per cent over the same period. As for Japan, output was down 20 per cent year-on-year.
So far, there is little evidence that the policy stimulus is working well. There are two big problems. First, what is the right amount of policy stimulus? The answer depends on the scale of the expected problem. Given that policy changes have an impact on economic activity only with a lag, policymakers need to gauge their actions according to projections of where the economy might be heading.
A year ago, no one was able to forecast the extent to which the global economy was about to fall off a cliff, so policymakers were unable to come up with a series of stimulus plans back then which would have carried any credibility either politically or in the world's media. Making a judgment on likely economic outcomes associated with the latest stimulus measures requires a huge leap of faith with regard to the path for the world economy in the absence of these measures. Knowing, for example, that a stimulus package will add, say, one per cent to the level of GDP tells you very little about the actual growth rate.
Second, the stimulus needs to be credible. As interest rates sink to zero, as central banks buy up stacks of financial assets and as governments run bigger and bigger budget deficits, policymakers need to offer cogent explanations to the public of why these policies will actually work. Quantitative easing becomes the default monetary policy only once interest rates have dropped to zero. Given that quantitative easing is typically not used in normal economic circumstances, it comes across very much as a second best option. The public, rightly, will wonder whether it will really work.
The "something must be done" approach to economic policy is all very well, but the overriding impression at the moment is that policymakers are not sure what is to be done as both the scale of the economic problem turns out to be bigger than expected and the conventional ammunition runs dry. Policies are increasingly being adopted through force of circumstance and the political desire for action, not as a result of a cold analysis of what is likely to solve the current crisis. After all, many of the policies now being adopted were precisely those which met with total rejection in the 1980s and 1990s.
The underlying problem faced by policymakers is a massive breakdown of trust in the functioning of the financial system, a difficulty which cannot be fixed overnight.
Conventional economic policies typically cast their spell on the economy via banks and other financial intermediaries. The case for unconventional policies ultimately rests on the idea that the financial system has to be bypassed in an effort to "protect" the real economy from the dangers of a Depression-style economic meltdown. While there is nothing necessarily wrong with this approach, the best that can be hoped for from these policies is a cushioning of the downside risks. We are now in a world of damage limitation, not a world in which recovery lies just around the corner.
• This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.