Central Banks: Doing more harm than good?

Central banks are working overtime to kick start the global economy but monetary policy is being relied on to do too much and may just be creating more problems.

With the global economy in a slump and monetary policy not gaining much traction, it seems natural for there to be doubts about the ability of central banks to manage fluctuations in the economy.  But it is not just an issue of whether monetary policy is working or not, but the questions extend further to whether the actions of central banks have intensified the swings in the business cycle.  Your Neighbourhood Economist has started to wrestle with his own concerns as even more creative monetary policies seem to be having little effect but the finger for blame should not be pointed at central banks.

The standard format of monetary policy revolves around the setting of interest rates.  The desired effect of any policy intended to lower the interest rates is to spur investment by making borrowing cheaper.  This basic policy format was deemed to be sufficient to deal with previous recessions over the past few decades and helped to build up a sense of infallibility that bolstered the reputation of central bankers such as Alan Greenspan.  But the extent of damage to the economy resulting from previous recessions, such as following the plunge in tech stocks in 2000 and 2001, was superficial in comparison to the global financial crisis.  As such, tinkering with the interest rates was enough to get the economy moving again in the past but interest rates close to zero have had little impact this time around.

The critical functions of finance having stalled in the aftermath of the current crisis with banks holding back from lending due to heavy losses in the finance sector coupled with new restrictions on their activities.  It is typical for recessions resulting from a banking bust to be longer and deeper so central banks have delved into a range of unconventional policies such as quantitative easing to kick start the economy.  The money supply has swelled up as central banks have been printing bundles of cash and providing banks with cash to splash out on lending.  Yet, the larger money supply has not fed through to make any substantial effect on the economy.  The surplus money sloshing around has been flowing into the non-productive parts of the economy such as asset prices rather than into businesses which produce assets and liabilities. 

It is this excess money that can jump around the global economy and cause unnecessary volatility.  Central banks act in a way to maintain this surplus cash in the global financial system due to a bias in their policies regarding periods of strong and weak economic growth.  Interest rates are slashed with further measures rushed out when the economy is on the slide but central banks are less aggressive in resetting interest rates to appropriate levels when growth takes off.  Furthermore, the perceived receptiveness of the economy to oversight by the central banks during only mild fluctuations in the economy has increased the faith in monetary policy to shield the economy from shocks.  So, when the economy is booming, the prices of real estate and share prices soar due to the excessive confidence of investors and households who think that the good times will last.  Spending by household increases while debt rises and savings drop off as people think themselves to have more money in these assets despite some of the rise in wealth being transient. 

Banks also act to extenuate the inflation of asset prices by increasing lending to further fuel this boom in property and the stock market while clamping down on new loans when things turn bad.   The finance sector was even more of a culprit in the build-up to the current banking bust due to new innovations when banks thought they could offload lending risks to other parties.  However, this just resulted in an underestimation of risk which blew up in many bankers’ faces during the crisis.  Support from governments and central banks for the finance sector adds to the reasons why banks would want to make bigger bets when economic growth is perky. 

Too much has been expected of monetary policy and this is having adverse effects on the economy.  Central banks have been given oversight of the long-term health of the economy while politicians can pander to the preferences of voters (see More Power to Economists for reasons why this is the case).  The absence of better management of government finances over the past decade has resulted in only limited options in terms of fiscal policy.  Increases in government spending would have been a more appropriate response to the current slowdown in economic growth as cash would have been fed into the real economy rather than just sitting in the vaults of banks as has been the case with the current monetary policy. 

As such, central banks have over extended themselves trying to kick start the economy.  There may be follow on effects from this as the huge quantities of money currently being printed by central banks are likely to exacerbate the trend of excess liquidity in the global financial system as it will be hard to mop up the extra cash once the economy starts moving again.  There are many villains in the tale of the missing economic growth – central banks may be seen as one of them but it is only because monetary policy is being called on to save the day when all else has failed.