Op­tions lim­ited be­fore next re­ces­sion

The Pak Banker - - OPINION - Martin Wolf

WHAT might cen­tral banks do if the next re­ces­sion hit while in­ter­est rates were still far below pre2008 lev­els? As a pa­per from the Lon­don-based Res­o­lu­tion Foun­da­tion ar­gues, this is highly likely. Cen­tral banks need to be pre­pared for this even­tu­al­ity. The most im­por­tant part of such prepa­ra­tion is to con­vince the pub­lic that they know what to do. To­day, eight-and-a-half years af­ter the first signs of the fi­nan­cial cri­sis, the high­est short-term in­ter­ven­tion rate ap­plied by the Fed­eral Re­serve, the Euro­pean Cen­tral Bank, the Bank of Ja­pan or the Bank of Eng­land is the lat­ter's half a per cent, which has been in ef­fect since March 2009 and with no rise in sight. The ECB and the BoJ are even us­ing neg­a­tive rates, the lat­ter af­ter more than 20 years of short-term rates of 0.5 per cent, or less. The plight of the UK might not be that dire. Nev­er­the­less, the lat­est mar­ket ex­pec­ta­tions im­ply a base rate of roughly 1.6 per cent in 2021 and around 2.5 per cent in 2025 - less than half as high as in 2007.

What are the chances of a sig­nif­i­cant re­ces­sion in the UK be­fore 2025? Very high in­deed. The same surely ap­plies to the US, Eu­ro­zone and Ja­pan. In­deed, the im­bal­ances within the Chi­nese econ­omy, plus dif­fi­cul­ties in many emerg­ing economies, make this a risk now. The high-in­come economies are likely to hit a re­ces­sion with much less room for con­ven­tional mon­e­tary loos­en­ing than be­fore pre­vi­ous re­ces­sions. What would then be the op­tions? One would be to do noth­ing. Many would call for the cleans­ing de­pres­sion they be­lieve the world needs.

Per­son­ally, I find this idea crazy, given the dam­age it would do to the so­cial fab­ric. A se­cond pos­si­bil­ity would be to change tar­gets, pos­si­bly to ones for growth or level of nom­i­nal gross do­mes­tic prod­uct or to a higher in­fla­tion rate. It would prob­a­bly have been wise to have had a higher in­fla­tion tar­get.

But chang­ing it when cen­tral banks are un­able to de­liver to­day's lower tar­get might desta­bilise ex­pec­ta­tions with­out im­prov­ing out­comes. More­over, with­out ef­fec­tive in­stru­ments a more am­bi­tious tar­get might just seem empty bom­bast. So the third pos­si­bil­ity is ei­ther to change in­stru­ments or to use the ex­ist­ing ones more pow­er­fully. One in­stru­ment, not much dis­cussed, would be to or­gan­ise the delever­ag­ing of economies. This might need forced con­ver­sion of debt into equity. But, while de­sir­able in ex­treme cir­cum­stances, this would be prac­ti­cally dif­fi­cult. An­other would be a still big­ger scale of quan­ti­ta­tive eas­ing. At the end of the third quar­ter of last year, the BoJ's bal­ance sheet was 70 per cent of GDP, against less than 30 per cent for the Fed, the ECB and the BoE. The lat­ter three could fol­low the for­mer. More­over, the as­sets they buy could be broad­ened, one pos­si­bil­ity be­ing for­eign-cur­rency bonds. But that would be provoca­tive and un­nec­es­sary. The BoJ and ECB have en­gi­neered big cur­rency de­pre­ci­a­tion with­out mak­ing it quite so bla­tant.

Yet an­other in­stru­ment is neg­a­tive in­ter­est rates, now used by the ECB, the BoJ and the cen­tral banks of Den­mark, Swe­den and Switzer­land. With clever gim­micks, it is pos­si­ble to im­pose neg­a­tive rates on bank re­serves at the mar­gin, thereby gen­er­at­ing neg­a­tive in­ter­est rates in mar­kets, with­out im­pos­ing neg­a­tive rates on de­pos­i­tors. How far this can be pushed while cash is still an al­ter­na­tive is un­clear. Be­yond a cer­tain point, peo­ple seek to move into cash­backed ware­house re­ceipts, un­less a pe­nal tax were im­posed on with­drawal from banks or cash were abol­ished al­to­gether. More­over, it is un­clear how eco­nom­i­cally ef­fec­tive neg­a­tive rates would be, apart from low­er­ing the cur­rency. A fi­nal in­stru­ment is "he­li­copter money" - per­ma­nent mon­e­tary emis­sion for the pur­pose of pro­mot­ing pur­chases of goods and ser­vices ei­ther by the govern­ment or by house­holds. From a mon­e­tary point of view, this is the equiv­a­lent of in­ten­tion­ally per­ma­nent QE. Of course, ac­tual QE might be­come per­ma­nent af­ter the event: that is now likely in Ja­pan. Again, sup­pos­edly per­ma­nent mon­e­tary emis­sion might turn out to have been tem­po­rary, af­ter the event. But if the money went di­rectly into ad­di­tional spend­ing by govern­ment or into lower taxes or to peo­ple's bank ac­counts, it would surely have an ef­fect. The cru­cial point is to leave con­trol over the quan­tity to be emit­ted to cen­tral banks as part of their mon­e­tary re­mit. Per­son­ally, I would pre­fer the last in­stru­ment. But at this stage it is cru­cial to recog­nise the great like­li­hood that some­thing even more un­con­ven­tional might have to be done next time. So pre­pare the ground be­fore­hand. Cen­tral banks should be fill­ing in th­ese blanks now, not af­ter the next re­ces­sion hits.

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