The Bank of England’s extraordinary 1.5 percentage point interest rate cut to 3 per cent is scary, justified and irrelevant. It is scary because it confirms the British economy may be headed for one of the biggest slumps since the second world war. It is justified in the sense that falling inflation rates give central banks sufficient room for manoeuvre. But unfortunately, it will not make much difference to the prospects of an economic recovery.
A stronger eurozone rate reduction by the European Central Bank, which cut by half a percentage point to 3.25 per cent, would also have been desirable and justified, but likewise irrelevant.
The reason is that the channels through which monetary policy affects the real economy are still clogged. There are several such channels, including ones for bank lending. But most of them go through the money market, as neither companies nor households have direct access to central bank money. To the extent that the money markets are not working properly, monetary policy is correspondingly ineffective.
As British variable-interest mortgage holders discovered to their dismay last week, most banks were initially reluctant to pass on the Bank of England’s cut, although they later said they would do so. The rates that matter to mortgage-holders are short-term or long-term mortgage rates, depending on the type of mortgage they hold.
What matters to many companies is the London interbank offered rate (Libor), or the Euribor in the eurozone. Large companies often fund their short-term liquidity needs on the commercial paper market. The US Federal Reserve has cut the Fed funds rate from 5.25 per cent in September 2007 to 1 per cent recently. But 90-day commercial paper rates were a little over 5 per cent when the crisis started in August 2007 and still close to 5 per cent last month. Only recently have they fallen to 3.3 per cent, and only after the Fed started to intervene in this market directly.
There has since been a slight improvement in money market conditions. But money market rates are still in the red-alert zone. The Ted spread, which measures the difference between three-month dollar Libor rates and three-month US Treasury bill rates, was still above 2 per cent towards the end of last week. It was near 1 per cent for most of the crisis and just a touch over zero before.
Perhaps an even bigger problem than the persistence of high interest rates is the fall in credit volumes. Banks have been cutting down on all types of loans, for mortgages, consumer credit and businesses. Interest rate cuts have no short-term effect on volumes.
At this juncture, monetary policy is playing little more than a supporting role during this crisis.
The most potent policy instrument we currently have at our disposal is fiscal policy. Unusually for a European central banker, Mario Draghi, governor of the Bank of Italy, last week called on governments to use whatever room for manoeuvre they had on fiscal policy. He is right. The gradual improvement in money market conditions will not be sufficient to stop the dramatic deterioration in economic activity, as witnessed for example by the horrific car sales figures last week.
While there have been some sporadic national initiatives, there is as yet no effective global response.
The world suffers from a fiscal collective action problem. The countries where a stimulus would be most effective are China and Germany. But these also happen to be the countries least willing to adopt such policies. Both have massive current account surpluses and relatively low rates of domestic consumption. The US and the UK, meanwhile, are more willing to employ a fiscal stimulus, yet their economic situation is less suited to it.
As Stephen Cecchetti, chief economist of the Bank for International Settlements, once reminded us, good fiscal stimuli are timely, targeted, and temporary. Another important element is their size. They have to be sufficiently large for impact, but not large enough to risk deterioration in a country’s solvency.
The €5bn ($6.4bn, £4bn) stimulus announced by Germany is quite unique in that it fails almost every test of a good stimulus plan. It is full of political pork barrel and it is puny. On my calculations Germany needs a stimulus at least 20 times the size, of about €100bn, largely in the form of tax cuts, to boost consumption, especially now ahead of Christmas. Tax cuts would also work well in Italy. In the US and the UK, other fiscal measures might be preferable at this point.
The way to get to this position is global policy co-ordination. If the eurozone and China pull their weight, a $500bn US stimulus would be a lot more effective than otherwise. Co-opting the eurozone and China into a global response will be the key component of financial diplomacy in coming weeks. This may have to wait until next year, when it will become a policy priority for the new US president.
Fiscal policy, more than monetary policy, will determine how and when this crisis will be resolved. The best contribution central banks could make is to help the money markets. I still believe some explicit currency-zone level money market insurance scheme is the way to go. By all means, cut those interest rates if you think there is room for manoeuvre. But do not kid yourself. The effect is somewhere between zero and not very big.
No comments:
Post a Comment