Interest Rates – low but not low enough

Interest rates may not be low enough to get us on the road to recovery but falling prices should help

Something strange is afoot in the economy.  With interest rates at record lows in many countries, borrowing should be booming and saving on the decline but the opposite is true.  This suggests that the economy remains out of kilter without interest rates being able to set the right balance between savings and investment.  Instead, the shortfall in demand due to limited investment and weak spending may be dragging down prices as a means to put the economy back to health.  

Not so free market

The self-healing ability of any economy is one of the central tenants of economic theory.  Prices adjust as a means for the economy adapting to any changes.  For example, an increase in the supply of bananas will trigger a fall in prices and more people eating bananas.  A rise in companies looking for software experts would drive up their wages (the price for labour) and the number of people wanting to learn more about computers.  Through changes in these prices, the economy moves toward an equilibrium where everything is at appropriate levels.

Interest rates act in the same way acting as the “price of money” to make sure that there is neither too much nor too little savings or investment.  Lower interest rates are used to make borrowing cheaper and savings less worthwhile.  This was the course of action taken by central banks in order to stimulate the economy by attempting to boost investment (funded by lending) and spur on more consumption (due to lower savings).  Quantitative easing adds to this by giving banks more money to lend and less need to entice people to leave money in the bank.

Still waiting

The continued wait for a robust recovery suggests that something remains amiss.  The lack of appetite among companies to expand their operations by borrowing is both a cause of and caused by weak demand in the overall economy.  Spending by consumers is also faltering with people happy to let money mount up in the bank despite the low returns on savings.  The high levels of household debt that still persist are another reason for consumers to hold back from spending.

The persistence of the state of low investment and high savings suggests that monetary policy has not been enough to get the economy back on the right track (although it has helped to prevent a financial collapse).  A further loosening of monetary policy is not on the books for most central banks.  Interest rates cannot be lowered much further considering that negative interest rates are difficult to implement.  Quantitative easing also seems to have run its course while increasing creating negative side effects. 

Where to next?

The inability of interest rates to adjust is hampering a return to economic growth.  With interest rates not able to go any lower, it may be the case that it is prices which are instead moving to get the economy back to equilibrium.  That is, rather than interest rates falling to balance out weak lending and growing savings, prices are being depressed by the lacklustre economy.  The hopes for economic recovery rely on cheaper prices spurring on more spending thanks to consumers felling richer.  Further impetus would result from the extra spending helping to push up investment and lift the economy to better match the current level of interest rates.

This route back to recovery may take time considering that any decline in prices will be limited and wage gains have yet to take off.  There are ways to push this along of which easiest way would be for governments to temporarily increase spending.  Money used for investments in infrastructure or training and R&D in new technologies would be worthwhile at a time of low interest rates.  Another alternative would be for central banks to use their money-printing capabilities to transfer cash to consumers.  This more radical option would provide a short-term boost to spending.  Sometimes we all need a little bit extra to get us back on track and the economy is no different.

Property Market – nowhere to call home

House prices are distorted by demand from investors and governments are making the situation worse

Houses have become so much more than homes and many of us are missing out as a result.  More than just a place to live, houses have become the investment option of choice during turbulent times.  The popularity of investment properties means that buyers looking for a home are being crowded out of the market.  Rather than correcting this distortion, government policies typically make things worse and leave the dream of their own home beyond the hopes of many.

No home sweet home

The property market is never far from any topic of conversation.  Since everybody needs a place to live, it affects us all.  The substantial price tag that comes with buying a house would be enough to weigh on anyone’s mind.  But property purchases take on even greater significance as real estate also counts as a form of saving for the future.  The money tied up in property is the biggest investment that many of us make.  This means that the ups and downs of the housing market shape the financial well-being of many families. 

The predominance of property investment is further accentuated as buy-to-lets become increasingly popular as a means of putting ones wealth to work.  The abstract nature of shares and bonds along with the shenanigans in the financial markets makes property seem like the safe-as-houses option.  Yet this extra source of demand for real estate inflates house prices beyond their value as a mere place to live.  Investment in real estate brings benefits, such as providing rental accommodation and improvements to neglected properties, but the costs also mount as investment in property increases.

With a relatively fixed amount of housing in large cities, one person’s buy-to-let gets in the way of a house becoming a permanent home.  Along with the benefits to home owners, neighbourhoods also have a greater sense of community with stable residents.  The higher house prices due to property investment results in home ownership being coupled with a larger amount of mortgage debt.  This makes the property ladder more tenuous for debt-laden buyers who could easily be caught out by any economic hardship.

Need to make room for more

Governments, which could work to limit these negative consequences, tend to only exacerbate the problem.  Policies targeting the real estate market differ across countries – tax breaks for mortgage debt, low levels of capital gains tax, easier access to loans.  But the common thread is that it is all too tempting for governments to please better off voters by bolstering the property market.  The predominance of monetary policy as the main tool for managing the economy makes this even worse by stoking up borrowing (and the property market) when the economy is weak. 

While pushing up demand, governments do too little to boost supply.  It is more housing that is often cited by politicians as the solution to buoyant property prices but government regulations and zoning rules are not reflective of the growing need for new houses.  Houses take too long to build while elections are never far off even though more building would make for good economic policy at a time when the economy is still suffering from a shortfall in demand.

Financial markets are awash with other places to invest.  Our animal spirits should be limited to parts of the economy where the ups and downs can be absorbed without wider consequences for the rest of us.  Housing is too important to get caught up in such investment games.

Fiscal Policy – Not fighting back

The government has been subdued in the fight to revive the economy despite a change in strategy being long overdue

Considering the trouble we are having fighting back against the aftermath of the financial crisis, it seems strange that the government is not using its full arsenal.  Central banks have come out all guns blazing with their monetary policy but governments have held back from firing up fiscal policy.  Worries about their levels of debt were behind this tepid response by governments but such concerns have eased while the economic recovery struggles to pick up momentum.  Why should be suffer further losses while saving our ammunition?

Hit and miss

Central banks launched themselves into the front line while governments remained in the background due to self-inflicted wounds.  Monetary policy had been enough to deal with past recessions and resulted in a belief that central banks were infallible in this regard.  High levels of debt along with a banking sector under attack meant that low interest rates had little effect and quantitative easing was not much better.  Along with not making much headway, monetary policy also caused considerable collateral damage in the form of financial instability.  This was a sign that central banks were being asked to do too much in the face of a once-in-a generation economic slump.

Most governments were happy to sit back having mismanaged their finances resulting in high levels of government debt prior to the crisis.  The Eurozone crisis prompted governments to further retreat amid worries that investors would shun any government with too much debt.  This pushed governments off on a trajectory of austerity which continued even though fears about government debt abated within several months.  The economic recovery has been muted due to weak demand with companies not willing to invest despite low interest rates and consumers hurting due to large debts and stagnating wages.

Time for a new battle plan

Monetary policy was always likely to struggle to make much ground while there is little impetus to spend, let alone borrow.  This shortfall could be overcome by the government which fixes problems, from crime to pollution, that are caused by others.  Keeping the economy ticking over when spending would otherwise be weak would prevent more damage being done to the economy.  Otherwise, the economy becomes less productive as firms stop investing in new technologies and the skills of people out of work deteriorate.

It seems an even more obvious solution at a time when there is so much that the government could spend its money on such as improving Internet access, accelerating the uptake of renewable energy, and updating transport infrastructure.  The low interest rates provide the perfect opportunity to invest for the future especially when companies are not up to doing so.  Investment projects could be set up to boost output in the economy for a few years until spending from other picks up the slack. 

A winning strategy

Despite the still faltering economic recovery, governments loathe changing direction and austerity continues to reign in Europe and the UK (as well as US to a lesser extent).  Moves to fix government finances made sense following the jump in interest rates on government debt in the Eurozone but this turmoil in the financial markets has long passed.  Weak overall spending and the threat of deflation setting in is now the dominant problem facing many countries. 

Higher spending by the government that lifted the productivity of the economy could be funded through borrowing at low interest rates and repaid through higher taxes that a more efficient economy would generate.  This is the opposite of what is happening in the UK where austerity is hurting the economy and efforts to reduce the government deficit are being thwarted due to a fall in money from taxes. 

There is still time for a change of strategy to have an impact in the fight for an economy recovery that improves the lives of us all.  Even if it is too late, investing for the future when interest rates are at record lows seems like a no brainer.  A change is due as this is a battle that no one wants to lose.

Getting more from Monetary Policy

Japan has made lots of mistakes and it is time that Europe learnt from them

We can all learn from watching others make mistakes and the experiences of Japan continue to provide valuable lessons.  Japan has stumbled into another recession following a hike in taxes to fix the government’s finances.  The other key policy doing the rounds in Japan, using expansive monetary policy to put an end to deflation, also seems to be flagging.  It is Europe that has most to learn from the unfortunate trials and tribulations in Japan since many of the same problems are shared by both.  What should Europe do to avoid making the same mistakes and decades of stagnation?

Following in the same footsteps

Japan has been hit first with many of the same problems that are increasingly expected to plague Europe and other Western countries.  For starters, new-borns in Japan are increasingly outnumbered by pensioners which have pushed the population into decline in recent years with an aversion to immigration further accentuating this trend.  This translates to fewer workers to provide the taxes needed for the rising costs involved with taking care of old people.  The situation is made worse by government debt which is already more than double GDP due to years of inefficient government spending.

Japanese consumer prices have been falling for years as a reflection of the weak demand.  There are few opportunities to profit from in Japan due to the falling population and even Japanese firms are looking elsewhere to invest.  Weak global demand means that even one of Japan’s strengths, exporting, offers only limited respite even with a weaker yen due to its loose monetary policy.  All of this means that the Japanese economy itself is like a tottery pensioner - even a small rise of sales tax from 5% to 8% was enough to push Japan back into recession.  This does not bode well for Europe where the economy is sputtering along due to many of the same problems while the governments there are also trying to get a grip on their finances.

Trying different directions

Having been stuck with these problems for longer, policy makers in Japan are increasingly more aggressive in coming up with solutions.  The current prime minister, Shinzo Abe, launched a raft of new measures dominated by a massive expansion of the money supply to target falling prices.  This new aggressive approach to monetary policy was facilitated by the government installing a new governor to the Bank of Japan who was willing to give up its independence and toe the line.

This is the complete opposite to the situation in Europe.  The head of the European Central Bank is eager to do more with monetary policy but is prevented from doing so by the German government.  German politicians want to reforms to come first due to an expectation that their neighbours will not implement the necessary policies. Whereas, in Japan, the aim was to use the loose monetary policy to help build momentum that will allow the government to implement reforms. 

Yet, the Abe government has been disappointing in its reform efforts (as Your Neighbourhood Economist predicted) and this will bolster the stance taken by Germany.  With the Bank of Japan finding it tough to generate sufficient inflation despite a rapidly expanding money supply through quantitative easing, many will question about the reasons behind using a similar policy in Europe.  Central banks are struggling to have much influence in a world that is already awash with surplus cash.  

Time for Plan C

It seems like the key lesson from Japan is that monetary policy cannot do much by itself.  Japan still languishes despite the best efforts of the central bank as the Abe government shirks the much needed measures to free up the economy.  Yet, bullying countries in Europe to reform by withholding the full extent of monetary policy is not helpful either.  A grand bargain marrying reforms with looser monetary policy, as was supposed to be the case in Japan, seems the obvious solution. 

This takes more political willpower when the many countries of Europe are involved but is not something beyond the realms of possibility.  Ironically, the chances for such a deal may be improving as deflation becomes more of a concerns and the economic stagnation in Europe also spreads to Germany.  Japan has already paid the price for years of economic mismanagement – there is no reason for Europe to do the same.

Question – where next for Japan

An inquiry from a reader prompts Your Neighbourhood Economist to look into the prospects for Japan

There has been another knock at the door of Your Neighbourhood Economist, with a reader what I thought Japan should be doing in the short and medium term?  The question arrived just days before another big policy development in Japan with the central bank ramping up its monetary policy.  This is the latest attempt by policy makers in Japan to resurrect an economy that has been languishing for decades.  To get an idea of what Japan should be doing, we need to start with what went wrong and why Japan has not made much progress.

What is not going right?

Japan got itself into trouble in the 1980s with the spectacular collapse of a financial bubble from which it has never recovered.  Property prices have fallen almost every year for two decades while prices for consumer goods have been inching lower for almost as long.  Japan has repeatedly tried to use fiscal stimulus but higher government spending has been unable to mask deeper problems with the economy.  Along with numerous roads and bridges which are hardly used, the main result of these rescue attempts has been a ballooning amount of government debt which only adds to Japan’s woes.

Monetary policy has been adopted recently as the potential saviour in the fight against what has been deemed as the main problem – deflation.  Falling prices were seen as prompting consumers to hold off spending and preventing companies from investing.  With this in mind, the central bank in Japan announced plans to double the money supply in early 2013.  But the policy of pumping more money into the economy was based on the false logic that deflation was a problem rather than just the symptom of a weak economy.  Instead, it is likely the case that deflation persists because prices rises had gotten out of hand in the past and need to fall back to appropriate levels.

Fix-up job not working

The result of this monetary policy has been as Your Neighbourhood Economist might have expected with just a brief and temporary boost to inflation.  Prices for consumer goods cannot rise consistently if consumers themselves do not get a similar rise in pay.  Higher wages in Japan seem unlikely as a declining population hurts aggregate demand and Japanese firms invest more overseas than domestically.  Yet, rather than change tact, Japan’s central bank has opted for more of the same. 

This involves the Bank of Japan aiming for an even larger boost to the money supply in Japan with annual purchases of 80 trillion yen (US$720 billion or £450 billion) in government bonds.  The timing of the new policy comes as the Japanese economy is faltering under the added weight of a tax hike designed to fix the government’s finances.  Japan has gotten itself deeper and deeper into trouble and seems likely to be an example of what not to do in terms of fiscal and monetary policy.   

Where to from here

The best option left to the Japanese government is to reform the economy so as to increase competition and improve efficiency.  There is substantial domestic opposition to reforms even within the current government headed by Prime Minister Shinzo Abe who included reforms as one of his key policies.  An easy way to sidestep domestic politics would be to jump on-board to plans for the Trans-Pacific Partnership (TPP).  This is a free trade agreement with the United States, Australia, Mexico, Chile, and other countries around the Pacific Rim.

Left to themselves, Japan will probably continue to stagnated due to the stifling effects of its consensus style of politics which make it tough to come up with reforms that keep everyone happy.  As such, Japan has a history of positive change only coming when imposed from the outside and this free trade agreement looks likely to follow this trend.  Greater competition from foreigners will help lower costs of business and create impetus for freeing up businesses in Japan from a host of restricting rules.  Facing up to the outside world looks like the best way to inject life back into a Japanese economy that has been slowly decaying for years.

Economic Recovery and the Politics of Slow Growth

When the economic pie stops expanding, everyone wants their fair share and politicians are unfortunately only to keen to oblige

Slow economic growth is like hot weather – people become easily irritable and argue a lot.  This because, while economic growth makes it easier for everyone to feel better off, the opposite is true when the economy stagnates.  A sluggish economy leads to a shift in focus from creating more wealth to dividing up whatever is already there.  This creates fights over resources with people mostly looking out for themselves. 

Politicians pander to such self-interest among voters and constructive policy making goes out the window.  Voters are get all hot and flustered as the economic recovery since the global financial crisis has proven anything but balmy.  With the outlook for the economy not looking so bright for years to come, politics may continue to get people steamy under the collar.

Politics turns cold

Democracy is the best political system we have for ensuring the implementing of policies for the common good.  Politicians get elected by pushing a package of measures that the majority of voters believe will make them better off.  When times are good, policies tend to be aspiration in promoting economic growth with some resources also going to the less well off.  But things are not going so well, the focus of voters narrows to their own specific well-being.  As such, voters become less generous in terms of social spending and immigration while wanting the government to do more for them. 

The result is that politics become short-sighted and politicians pick more policies that target their own particular support base.  Honest assessment of the economic ills are typically in short supply while voters grow increasing frustrated as timid government policies can only provide limited relief.  Many voters have been tempted with the false hopes of more extreme policies offered by populist politicians.  However, turning back time with less government or less globalization will only create bigger problems rather than providing answers. 

The political infighting comes at a bad time for many developed countries who are increasingly feeling the heat of global competition.  This process was already underway with the rise of China and other emerging economies and the global financial crisis has been a further setback.  The narrow-minded politics currently prevailing in many countries will further hasten the relative decline of the West.  On top of this, government action is also hampered by economic theory that argues for less intervention in the economy. 

Still sweating it out

It is more than a tad ironic that it is now more than ever that positive and proactive government measures are needed more than ever.  This is because government has traditionally been the guardian of the long-term health of society.  The government has even more to offer at a time when businesses are not investing and gains in productivity (output per worker) are proving hard to come by.  Higher productivity is the main route to increases in wages and consumer spending at a time when low skilled work is carried out in developing countries.   

Yet, as described above, governments have been more of a hindrance rather than helpful with regard to the economy.  A push for austerity has dominated in many countries such as the UK despite going against the grain of economic theory.  In the place of increasingly distracted politicians, central banks have take centre stage in reviving the economy (which comes with its own problems).  With minor squabbles often dominating politics, it may take time before governments and voters are ready to sweat over the big issues.  Like a muggy summer that never seems to end, the combination of economic and politic malaise is not a problem that will go away any time soon.

Question – Interest rates

In response to an inquiry from a reader, Your Neighbourhood Economist explains how low interest rates should have but didn’t affect the economy (with a surprising culprit)

Your Neighbourhood Economist was pleasantly surprised to have a proverbial knock at the door (a photo of which was posted on the blog recently along with an email address for questions) with the following inquiry on interest rates…

I read your blog entry on BOE interest rate hike and needed an opinion. I'm not a finance student but am trying to understanding why something so unusual is happening with the BOE interest rate. You have explained why there is a need to hold the rate low at the moment, seeing there isn't enough inflation yet (as posted in UK Interest Rates – putting off the inevitable). But could you explain to me in layman's terms how this has affected our economy and what other solutions could have been used?

Interest rates are a hot topic at the moment with changes afoot at the Bank of England.  Sometime over the next six to twelve months, the UK central bank is likely to raise its benchmark interest rate off its record low of 0.5% where it has been for more than 5 years.  Low interest rates are the most common way that central banks will try to raise economic growth.  The theory behind this is that cheaper loans will push businesses and households into borrowing money and this extra spending will boost the economy. 

Good in theory but not in practice

In practice, things have not worked out so well.  Businesses have held off taking out loans due to uncertainty over the future direction of the economy.  Companies need to be assured of a decent return from any investment which will typically only make money over the span of several years.  Worries about the future earning potential of any new operations have outweighed the lower costs of borrowing money to invest.   As a result, business lending in the UK has fallen for seven consecutive years with companies preferring to hoard cash instead. 

The main benefactor of low interest rates has been the property market.  House prices in London held up despite the global financial crisis and added to the myth that property values never fall.  So once the worst of the crisis was over, low mortgage rates prompted many to scramble to buy property.  The buoyant housing market has boosted the economy a bit by making people who own property feel richer and spend more.  But more mortgages only pushes up house prices rather than making the economy more productive as investment by businesses would have done.

So the actual effect from low interest rates has been less than hoped.  This resulted in central banks also using quantitative easing – creating new money to buy bonds and other financial assets.  The aim of quantitative easing is increase the amount of money in the economy and help out the banking sector.   Quantitative easing too has been somewhat of a disappointment with few places for the extra cash to be put to good use.  The banking sector typically acts as one of the main means to move cash around the economy but banks have had to focus on their own survival.  The surplus of cash has created its own problems such as distortions in the financial markets which may cause trouble in the future.

Other solutions…?

With businesses not spending and mortgages not adding much to the economy, the obvious solution would be for government to make up the shortfall.  A fiscal stimulus is the typical response to a slowdown in the economy with the extra spending by government making up for weak demand from consumers and businesses.  Yet, government finances in the UK and elsewhere were already stretched before the crisis and deteriorated further with higher welfare payments and falling tax revenues following the crisis.

The Eurozone crisis from 2010 resulted in investors shunning any countries with high levels of government debt.  This prompted the UK government to launch its austerity program with the hope convincing investors that it would sort out its finances.  The plan worked in that the interest rates on UK government debt remained low (also with help from quantitative easing) unlike some countries in Europe such as Ireland and Spain.  However, cuts to government spending hurt the economy and prolong the slump in the economy while also ironically making even more cutbacks necessary.

Still struggling

Getting ourselves out of trouble following the global financial crisis was always going to be tough going.  Recessions stemming from banking crises are typically longer than normal recessions as it takes time to work down the excessive levels of debt and fix the banks.  Less expected was how the economic recovery has been further hampered by ineffective and lacklustre policies. 

Fiscal policy has been working in reverse and the UK government should do more to boost the economy considering that investors are no longer so worried about government debt.  The Bank of England could have done more with monetary policy considering that it can print as much money as it likes but it held back due to misplaced concerns about inflation.  Your Neighbourhood Economist would have liked to have seen more spending by the government and quantitative easing going straight into the economy.

Perhaps the biggest factor holding back the recovery is that economists are slow learners.  Policies such as quantitative easing are new and have helped but more could have been done if economists had not been so caught up with their own ideas.  It is of some consolidation that lessons from the Great Depression (such as the bank bailouts) have been applied to ensure that a similar type of crises has resulted in less fallout.  We can only hope that this crisis is bad enough to ensure better policy in the future.  

(Please add any further questions on this topic using the comments section at the bottom of the page or email any inquiries on different issues related to the economy to Your.Neighbourhood.Economist@gmail.com)

Drowning in Debt – Need Help

We are being pushed into borrowing our way back to economic growth but staying afloat also involves selling off our future

The last thing a drowning man needs is more water but this is how policy makers have chosen to react to the global financial crisis.  The global financial crisis came about due to consumers being allowed to take on too much debt in the past.  Yet, the policy response has been to push for greater borrowing by lowering interest rates and feeding money into the banking system.  Higher debt now can only mean greater repayments in the future.  This would be acceptable if a swift return to economic growth was on the way but this seems too optimistic.  Instead, while the economy is getting a temporary boost now, growing levels of debt are being forecast to depress the economy for years to come.

Cheap loans anyone?

The debt and water analogy works on many levels.  In the same way that water is essential for life to flourish, debt is needed for an economy to grow.  Yet, like water, too much debt can be as bad as not enough.  The appropriate level of debt depends on the pace of economic expansion.  Rapid economic growth will create greater demand for loans as business opportunities arise and asset prices rise.  Like a garden requires watering when the weather is hot, a booming economy can absorb more debt as the money generated through the loans makes it easier to fund debt repayments. 

The opposite is also true.  It is desirable to have fewer loans as an economy cools since paying off debt is tougher.  It seems a strange time to convince people to rack up more debt but that is what central banks are pushing for.  This is because the tools of monetary policy work by reducing the cost of money (through lower interest rates or printing more cash) when the economy is floundering.  Such policies make sense when assuming a rapid recovery in economic growth but even economists are pessimistic about the prospects for the global economy.

The other bail out option is for the government to ramp up spending through increased borrowing.  This is the typical response to dampened economic growth but concerns about high levels of government debt have limited the capacity for such a fiscal stimulus.  This has resulted in monetary policy having to take on the bulk of the heavy lifting in getting the economy moving again.  Businesses have typically not made use of the cheap credit on offer through the low interest rates (except to buy back their own shares).  It is the increased debt taken on by households that has been the main driver of economic recovery but this is neither balanced nor sustainable. 

Debt – paying the price

It is the role of policy makers to create an environment for encouraging economic growth.  Tough choices are necessary when few options are available but relying on households to pile up more debt seems irresponsible and short-sighted.  The ratio of earnings to house prices is on the rise at a time when wages are standing still.  This means that consumers will be saddled with debt repayments for longer (especially if house prices stagnate as is probable) and this will depress consumer spending in the future.  It seems a poor trade-off even at a time when the economy is underwater. 

This policy seems even dafter when considering that consumer debt is mostly unproductive.  Buying a house off someone else does not add anything to the economy (while spending on renovations does help a bit).  On the other hand, if the government were to borrow and spend more on education or infrastructure, this would increase the output capacity of the economy.  Yet, this sensible alternative is being dismissed even though investors are no longer shunning any government with excessive debt and interest rates on government debt are near record lows for many countries. 

It will ultimately be people like you and me who pay the price.  Our spending power is being put at risk at a time when the government’s own finances are drained and businesses are not putting their balance sheets in jeopardy.  It is likely to remain tough for many people to keep their heads above water and an economy saturated with debt may not provide much help.

Quantitative Easing – Get to the chopper!

What do you do when the economy needs a fiscal stimulus but there is no money for it?

Central banks have an ever expanding range in their toolkit to choose from to fix their individual economies but none of them seem to have worked so far.  This may be because they lack the right tool for the job.  In this case, the right tool is likely to be a large hammer in the form of a substantial fiscal stimulus but this is the preserve of governments who, at this point in time, are saddled with too much debt.  Yet, there is a way in which central banks could use monetary policy to act like a fiscal stimulus and generate the boost to demand that the global economy desperately needs.

Even new monetary policies are falling short

Economists thought we had it figured out.  Simply control the money supply by setting interest rates and it will be possible to ride out any booms and busts.  However, the weak recovery following the global financial crisis has shattered this belief.  Even manipulating the money supply using newly contrived measures such as quantitative easing has been less fruitful than hoped as well as creating unexpected problems. 

Quantitative easing has relied on a convoluted process where central banks create cash in order to buy bonds which frees up money for use elsewhere.  The problem has been that there is little demand for money in the actual economy as businesses are not keen to borrow as a result of the weak underlying economy.  Instead, what is needed is an instrument for inserting money straight into the economy.  This is because, rather than just cheap credit, companies need greater revenues from stronger sales in order to encourage investment and jump-start the economy again.

A fiscal stimulus fits the bill and has been tried already but only in small doses.  The key spanner in the works in this case has been high levels of government debt.  Before the crisis, politicians everywhere were almost as amped up as bankers and government finances were managed as if the boom time would continue forever.  The results have left us short of workable options to bolster the sluggish global economy.

Using Monetary Policy like a Fiscal Stimulus 

It may sound like a strange solution, but if monetary policy is not working and higher government spending is not possible, central banks could use their money-printing capacities to engineer a fiscal stimulus.  Rather than using freshly printed cash to buy bonds, central banks could just give it away.  Or, to use an analogy that economists like to use, drop money from a helicopter. 

Central banks operate the valves which control the supply of money, which is already being expanded on a temporary basis using quantitative easing.  The helicopter idea is a much more direct approach than shovelling money at the bond market.  Recipients of the cash would be free to spend it as they please, thus injecting money into the actual economy and creating a bonus for firms.  

The cash would not actually be in in the form of notes or coins but could be paid as a cheque or straight into the bank accounts of tax payers.  It strikes at the core of the main problem in the economy, a shortage of demand, allowing for more rapid results and less distortion compared to having surplus cash in the financial system.

The main drawback of this seemingly too-good-to-be-true policy is worries about inflation.  This is also the biggest obstacle as inflation is the primary concern of the central banks that would need to print the cash to be distributed.  It is the belief of many economists that it is the discipline of central banks which has kept inflation down over the past few decades.  Any sign that central banks might allow for more inflation is thought to push prices into a perilous upward spiral.  Yet, inflation is no longer the threat it once was and would not become an issue until the economic recovery was well under way.

Just like any handyman, economists have their favourite tools and are sometimes loath to admit that there might be a better option.  Unfortunately, it may just be a step too far for central banks to overcome their fear of inflation and leave the safety of familiar ground despite the extra firepower on offer.