By Joseph Eyre
As the Covid-19 pandemic passes the grim milestones of a year of devastation and two million deaths, the disruption caused and its implications on the future are becoming more clear. From the way we work, to action on climate and the economy, it’s fair to say that the post-Covid world will be radically altered as a result of a necessitated shift in thinking.
One such transformation is the increasing challenge to the existing economic orthodoxy of relying heavily on monetary policy to create growth and stability in the UK, with many now advocating for fiscal policy to play a greater role.
For some background, monetary policy is concerned with the supply of money in the economy and how much it costs to borrow money (interest rates). These are controlled by a nation’s central bank, such as the UK’s Bank of England (BoE), the EU’s European Central Bank (ECB), and the USA’s Federal Reserve (Fed), and these institutions are independent from the government. On the other hand is fiscal policy, which is concerned with the collection, through taxation and borrowing, and spending of revenue by governments.
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To understand the current state of monetary and fiscal policy, we need to look to the immediate aftermath of the 2007-8 financial crisis. To illustrate the severity of that crisis, and just how close we came to the total collapse of the financial system, Allistair Darling (UK Chancellor at the time) recently recalled a phone call at the height of the crisis where Tom McKillop, chairman of Royal Bank of Scotland, informed Darling that “we’re going to run out of money this afternoon.” By 2008, RBS had become the largest bank in the world and larger in size than the UK economy, and so the repercussions of its failure are hard to overstate. Fortunately, through enormous government bailouts totalling £500 billion in the UK alone, the immediate catastrophe was averted with only a few major banks going bankrupt. What remained, however, was the unenviable task of rebuilding a devastated economy.
Cleaning Up The Crisis
Desperate times called for desperate measures. The monetary policy responses of the Bank of England, ECB and Federal Reserve consisted primarily of lowering interest rates to historic levels and beginning an enormous programme of Quantitative Easing, both of which continue today. The fiscal policy response by these same nations was a programme of austerity, reducing public spending with the aim of reducing government deficits. All of these responses were, and still are, highly controversial.
Perhaps least controversial is the lowering of central bank interest rates. Broadly speaking, by lowering these, central banks discourage saving and encourage spending and borrowing with the overall aim of stimulating the economy. If companies are able to borrow money at a low cost, and consumers opt to spend instead of saving, then more goods and services will be exchanged in the economy, and this contributes to growth. In mid 2007, the interest rates of the Fed, BoE and ECB were all around 5%, but by 2009 their interest rates were at 1% or below and they have remained there ever since. Currently rates are at, or below, 0.25% and money has never been cheaper.
While low rates have undoubtedly contributed to the recovery from the financial crisis, it is not without complications. Lowering interest rates is an effective method of dealing with economic crises, and is a major component of a central bank’s toolkit. However, rates can only go so low, and raising them again is not easy; a prime example is Japan. The Bank of Japan lowered its interest rate to below 1% as a result of a financial crisis in the late 1990’s, and since 2000 it hasn’t risen above 0.5%.
(Quantitative) Easy Does It
Quantitative easing (or QE) has even greater complications. QE is a process by which central banks buy up vast quantities of financial assets, primarily bonds, in order to inject money into the economy. Initially, the majority of these bonds were government-issued bonds – essentially government debt and its interest payments. However, central banks now include corporate bond purchases in their QE programmes; the Bank of England, for example, began purchasing corporate bonds in 2016 as a response to Brexit-related uncertainty.
Bond markets, and government bonds in particular, are traditionally low-risk investments that offer a source of stable returns. However, as a result of these being bought by central banks, yields are at historic lows and barely beat inflation. The effect of this has been that investors, seeking decent returns, have moved their money into riskier assets such as property and shares. This has been a major contributing factor to the enormous rise in asset prices and subsequent inequality seen over the last decade; those owning assets have seen their wealth grow while those without have seen theirs’ stagnate.
Quantitative easing, considered to be “unconventional monetary policy,” has certainly contributed to the economic recovery since 2008 – and it has some other uses too. For example, the Bank of England is considering introducing stringent climate criteria on companies for its corporate bond purchases. So, while QE certainly has some positive effects and has the potential for more in the future, it has also been a significant cause of the economic inequality driving much of todays’ political instability.
Over-Reliable
This reliance on monetary policy is unsurprising given the extent of the dire fiscal situation many nations found themselves in after the crisis. Most nations were left with budget deficits of historic proportions and as a result, implemented programmes of austerity which were widely seen as necessary. As a result of these spending cuts, and the monetary policy responses, deficits steadily reduced and economies recovered. But despite this partial recovery, there remain many structural issues in the UK economy and many are shared by other developed nations.
Real wages, for example, have been largely stagnant, or decreasing, for decades. In the UK, real wages shrunk by 5% between 2008 and 2017. Even more problematic is the stagnation in productivity. Historically, UK productivity has grown at roughly 2% per year, but since 2008 has barely increased and now lags behind most other G7 nations. Furthermore, much like the US, the UK is also facing a significant infrastructure problem; congested roads, slow, overcrowded trains and poor broadband speeds are all significant issues. In 2017, the World Economic Forum ranked an inadequate supply of infrastructure as the second most problematic factor for doing business in the UK.
“Interest rates are set to remain low for a time long enough that we can reconsider what we do with fiscal policy.”
Laurence Boone – OECD Chief Economist
Evidently, while monetary policy measures and vastly increased liquidity have spurred economic growth in the short term, they have done little to address the chronic structural problems preventing sustainable and long term economic growth. Anneliese Dodds, the UK Shadow Chancellor, used her Mais Lecture to the Business School at City University London to make a similar case, and to advocate for a greater role of fiscal policy. She points out that while markets have “priced in low [interest] rates for the long term,” government should use these “benign circumstances to avoid choking off recovery via premature and politically-motivated fiscal tightening.”
Many would argue that that’s precisely what happened after 2008, whereby rapid and deep cuts to public spending damaged the prospects of long-term recovery. The OECD appears to agree, with the Chief Economist, Laurence Boone, encouraging governments to continue using fiscal policy to recover from the Covid-induced economic crises. The OECD was a major proponent of austerity post-2008 but now states that lessons should be learned, namely that governments should focus on long-term sustainability rather than short-term numeric targets and accept that public debt burdens will rise until the crisis has passed.
This isn’t to say that any and all public spending will be a good investment. Infrastructure spending, for example, can result in expensive vanity projects of massive proportions and risk “paving the road to nowhere” with few notable returns. Public investment therefore needs to be well considered and effectively targeted. By taking advantage of low interest rates to increase effective investment in key areas such as infrastructure, education and green energy; governments can ensure a more sustainable, robust and equitable economic recovery than was seen in the decade after the 2008 crisis.
This report was compiled by Joseph Eyre. You can find Joseph on Twitter here.