The global economy is on extended sick leave and central banks’ actions so far have failed to contain the contagion. Despite aggressive measures to provide liquidity to markets, big central banks — from the US Federal Reserve and the European Central Bank to the Bank of Japan and the Reserve Bank of Australia — have not managed to stop big falls in asset prices or to shore up investors’ confidence. In the process, they have exposed three fundamental limitations of monetary policy.
First, the highly infectious nature of coronavirus means people are socially distancing themselves to contain the spread of infection. That is driving a global shutdown of non-essential economic activities, delivering simultaneous shocks to global supply and demand. In China, where it began, the quarantine and partial shutdown resulted in a sharp fall in output, from manufacturing to services, which both contracted to levels lower than seen during the global financial crisis.
As the virus spreads to Japan, South Korea, Europe and the US, the sharp drop seen in Chinese activities in February will probably be reflected in these regions too. And if China’s rate of resumption is any indication, recovery on the supply side will be gradual, while demand-side shocks will be strong and frequent.
Manufactured goods can be stored, but losses in income from services are irrecoverable. That affects non-tradeable sectors most severely, especially small and medium-sized enterprises with less ability to withstand shocks to cash flows. The world has unfortunately become less material as services have risen in importance, from 62 per cent of global gross domestic product in 2007 to 65 per cent in 2018.
Second, central banks’ ability to help via interest rates is limited to the supply of liquidity. They are not able to address the credit and operational liquidity squeeze coming from a fall in earnings. Neither the Fed’s half percentage-point rate cut nor its massive injection of liquidity did much to assuage fears among investors. Given that it was not matched by proportionate fiscal support, investors sobered to the reality that even interest rates at zero could not offset such shocks to demand and supply.
Compounding this, the supply of liquidity by central banks is beneficial only to those who can access it. In this risk-off environment, with deteriorating expectations for corporate profits, banks are unlikely to lend to sectors already facing collapses in incomes, higher risks of default and a shaky outlook. Such conditions cover the majority of SMEs.
The big easing of financial conditions has yet to make a material impact on these businesses, as banks remain reluctant to lend to them. Targeted policy is thus required to overcome such limitations, given the importance of SMEs to employment and to gross domestic product. The People’s Bank of China’s targeted cut to reserve requirement ratios over the weekend, with certain commercial banks enjoying an additional cut of 100 basis points, is an attempt to overcome such a problem.
The third limitation is that the Fed, the ECB and the BoJ, and even central banks across emerging Asia, have burnt most of the wood they should have saved for winter. They slashed rates and expanded asset purchase programmes while real and nominal growth in GDP was positive.
This has meant that investors were operating in a financial system that systematically misprices risk, leading to the accumulation of larger volumes of higher-yielding assets to chase ever-suppressed returns. As Hyman Minsky said, “stability is destabilising”. We have had a decade of excess — and a Minsky moment of fragility last week.
The good news is that we still have space to engineer a U-shaped recovery to fight the fallout from the pandemic. In the short term we must focus on fixing the cracks in central bank transmission mechanisms, through more targeted policy. That is the best way to ensure the system does not collapse and the most vulnerable receive the emergency liquidity support they need.
As monetary policy is only helpful at the margins, fiscal policy is urgently needed to ensure that people can recover from the pandemic. More resources such as healthcare, income support for vulnerable households through short-term job schemes and cash handouts, as well as reductions in regressive tax burdens and even payroll payment deferrals, are needed. For firms most affected, fiscal policy should provide relief through short-term tax deferrals and liquidity support.
Finally, this pandemic should awaken the investment community to the limits of the powers of the central banks. If we want to avoid another Minsky decade, we need to reconsider the outsized presence of central bankers in markets.
The writer is senior economist for Asia emerging markets in the corporate and investment banking division at Natixis