Why economic policymakers need to respond aggressively

Yesterday I dug out some discussion notes I’d written while I was working at The Treasury during and just after the last New Zealand recession.  One of them –  written in June 2010, already a year on from the trough of the global downturn (although as the euro-crisis was really just beginning to emerge) – had the title “How, in some respects, the world looks as vulnerable as it was in 1929/30”.     The point of the “1929/30” was that the worst of the Great Depression was not in the initial downturn from1929 –  which, to many, seemed a more-or-less vanilla event – but from 1931 onwards.    It was only a four or five page note, and went to only a small number of people outside Treasury/Reserve Bank, but in many respects it frames the way I’ve seen the last decade, capturing at least some of issues that still bother me now, and lead me to think that  –  faced with the coronavirus shock –  macro policymakers should err on the side of responding aggressively (monetary and, probably, fiscal policy).

The more serious event –  akin to the 1930s –  didn’t happen in the last decade, at least outside Greece.    At the time, much of the focus of macroeconomic policy discussion  –  including in New Zealand –  was around ideas of rebalancing and deleveraging.    My note pointed out that, starting from 2010, it was very difficult to envisage how those processes could occur successfully over the following few years consistent with something like full employment.     To a first approximation it didn’t happen.  There was fiscal consolidation in many advanced countries, but not material private sector deleveraging. In most OECD countries it took ages –  literally years –  to get the unemployment back to something like the NAIRU.  And, of course, there was a huge leveraging up in China.  In much of the advanced world investment remained very subdued.

There were twin obstacles to getting back to full employment.  On the one hand, short-term policy interest rates in many countries had got about as low as they could go.  And on the other hand there was a view –  justified or not –  that fiscal policy had done its dash, and whether for political or market (or rating agency) reasons, further fiscal stimulus could not be counted on (even in a New Zealand context: I found another note I’d written a year earlier just before the 2009 Budget, which noted of “scope for conventional market-financed fiscal easing” that “our judgement –  more or less endorsed by the IMF and OECD – is that we are more or less at that point [scope exhausted]”.

The advanced world did, eventually, get back to more-or-less full employment.   But the world – advanced world anyway –  never seemed more than one severe shock away from risking dropping into a hole that it would be very hard to get back out of.  The advanced world couldn’t cut short-term interest rates by another 500 basis points.   For a time that argument didn’t have quite as much force as it does now –  when excess capacity was still substantial one could tell a story about not being likely to need so much policy leeway next time –  but that was then.  These days we are back starting from something like full employment.   There was also the idea of unconventional monetary policy instruments: but while some of them did quite some good in the heat of the financial crisis, and in the euro context were used as an expression of the political determination to hold the euro-area together come what may, looking back no one really regards those instruments as particularly adequate substitutes for conventional monetary policy (limited bang for buck, diminishing marginal returns etc).  And then there is fiscal policy.   Few advanced countries are in better fiscal health than they were prior to the last recession –  and New Zealand, reasonably positioned as we are –  is not one of the few, and the political/public will to use huge amounts of fiscal stimulus for a prolonged period remains pretty questionable.

Oh, and there is no new China on the horizon willing and able to have its own massive new credit/investment boom – resources wisely allocated or not – on a global scale to support demand elsewhere.

How about that monetary policy room?  Here are median nominal short-term interest rates for various groupings of OECD countries.

short-term 2020

You can see where we are 10 years ago.   Across all the OECD monetary areas (countries with their own monetary policy plus the euro-area) the median policy rate is about where it was then (of the two biggest areas, the US is a bit higher and the euro-area a bit lower).  Same goes for the G7 grouping.  And as for “small inflation targeters” (like New Zealand) those countries typically have much less conventional monetary policy capacity than they had in 2010 (New Zealand, for example, had an OCR of 2.75 per cent when I wrote that earlier note, and is 1 per cent now).

Back then, of course, the conventional view –  not just among markets but also to considerable extent among central banks –  was that before too long things would be back to normal.  Longer-term bond yields hadn’t actually fallen that far.  Here are the same groupings shown for bond yields.

long-term 2020

One could, at a pinch, then envisage central banks acting to pull bond yields down a long way (and with them the private rates that price relative to governments).  These days, not so much.  Much of the advanced world now has near-zero or even negative bond rates.  A traditionally high interest rate country like New Zealand now has a 10 year bond rate around 1 per cent.   Sure those yields can be driven low, but really not that much if/when there is a severe adverse shock.

And 10 years ago if anyone did much worry about these sorts of things –  and there were a few prominent people –  there was always the option of raising global inflation targets.  In the transition that might have supported demand and getting back to full employment. In the medium-term it would have meant a higher base level of nominal interest rates, creating more of a buffer to cope with the next severe adverse shock.   It would have been hard to have delivered, but no country even tried, and now it looks to be far too late (how do you get inflation up, credibly so, when most of your monetary capacity has gone, and it would hard to convince people –  markets –  of your sustained seriousness).

My other point 10 years ago in drawing the Great Depression parallels was that the Great Depression was neither inevitable nor inescapable.  But it happened –  in reality it might have taken inconceivable cross-country coordination to have avoided by the late 1920s –  and it proved very difficult (not technically, but conceptually/politically) to get out of.  The countries that escaped earliest –  the UK as a prime example –  did so through a crisis event, crashing out of the Gold Standard in 1931 that they would have regarded as inconceivable/unacceptable only a matter of months earlier.  For others it was worse –  in New Zealand the decisive break didn’t come until 1933, and even then saw the Minister of Finance resigning in protest.    If we get into a deep hole in the next few years –  international relations generally not being at their warmest and most fraternal, domestic trust in politicians not being at its highest –  it could be exceedingly difficult to get out again.  Look at how long and difficult (including the resistance of central banks to even doing all they could) it proved to be to get back to full employment last time.

In the Great Depression one of the characteristic features was a substantial fall in the price level in most countries.   The servicing burdens of the public and private debt –  substantial in many countries, including New Zealand/Australia –  escalated enormously, and part of the way through/out often involved some debt defaults and debt writedowns.

Substantial drops in the price level seem unlikely in our age.  Japan, for example, struggled with the limits of monetary policy and yet never experiencing spiralling increases in the rates of deflation (of the sort some once worried about).  But equally, inflation expectations ratcheted down consistent with the very low or moderately negative inflation, meaning real interest rates were never able to get materially negative.  Japan at least had the advantage that in the rest of the advanced world, nominal interest rates and the inflation rate were still moderately positive.

That could change in any new severe downturn.  A period of unexpectedly weak demand, with firms, households and markets all realising that authorities don’t really have much useable firepower, could see assumptions/expectations about normal rates of inflation dropping away quite sharply (in New Zealand they fell a lot, from a too-high starting point, last time round, even with unquestioned firepower at our disposal).  In that scenario, authorities would struggle to lower real interest rates at all for long –  falling nominal rates could quite quickly be matched with falling inflation expectations.  As people realise that, it becomes increasingly hard to generate a sustained recovery in demand, and very low or negative inflation risks becoming entrenched.  It isn’t impossible then to envisage unemployment rates staying very high –  unnecessarily and (one hopes) unacceptably high –  for really prolonged periods (check the US experience in the 1930s on that count).  An under-employment “equilibrium” brought by official negligence is adequately dealing with the effective lower bound on nominal interest rates.

I cannot, of course, tell if the current coronavirus is that next severe adverse shock.  But it looks a great deal as though it could be, and the risks are sufficiently asymmetric –  not much chance of inflation blowing out dangerously –  that we shouldn’t be betting that it won’t be.  Some people argue that since the virus will eventually pass for some reason it isn’t as economically serious as other shocks.   That seems wrong.  All shocks and recessions eventually pass –  many last not much more than a year or two  –  and the scale of disruption, and reduction in activity, we are now seeing (whether in the New Zealand tourism and export education industries, or much more severely in northern Italy, Korea and the like) has the potential to markedly reduce economic activity, put renewed downward pressure on inflation and inflation expectations (we see the latter in the bond market already), all accompanied by a grim realisation of just how little firepower authorities really have, or are really politically able to use.  (Ponder that G7 conference call tomorrow, and ask yourself how much effective leeway the ECB has now, compared to 2007, or even 2010. )

Against that backdrop, it would seem foolhardy now not to throw everything at trying to prevent a significant fall in inflation expectations, by providing as much support to demand and economic activity as can be done.   That means monetary policy, to the extent it can be used –  in New Zealand for example, a central bank that was willing to move 50 points last August, on news that was weak but not very dramatically so, should be champing at the bit to cut at least that much this month.  The downside to doing so, in the face of a very real threat to norms around inflation –  and a likely material rise in unemployment – is hard to spot.  And since everyone knows monetary policy has limited capacity –  and those who haven’t realised it yet very soon will –  we need to see fiscal policy deployed in support, in smart, timely, and effective ways.   In some countries it is really hard to envisage that being done well –  the dysfunctional US in the midst of an election campaign, starting with huge deficits –  but there really is no such excuse in countries such as New Zealand and Australia.  (Oh, and of course –  and after all these years –  something needs to be done decisively re easing the effective lower bound.)

(There is, of course, widespread expectations of a huge Chinese stimulus programme.  That is as maybe, although it will bring both its own risks –  domestic ones just kicked a little further down the road –  and the risk of new immediate dislocations, including the possibility of a significant exchange rate depreciation, exporting (as it were) deflationary pressures to the rest of the world.)

We are only one serious adverse shock away from a very threatening economic outlook, where the limits of macro policy would mean it would be difficult to quickly recover from. By the day, the chances that we are already in the early stages of that shock are growing.  Perhaps it will all blow over very quickly, and normality resume, but (a) even if that very fortunate scenario were to eventuate, the risks are asymmetric, and (b) we’d still be left sitting with very low interest rates and typically high debt, one serious adverse shock away from that hole.


17 thoughts on “Why economic policymakers need to respond aggressively

  1. The recession in NZ during 2008 to 2010 was engineered by the RBNZ through aggressive interest rates rises. Residential Overdraft interest rates which our small businesses rely on are still around 5%. This is not low as it is secured against residential property. Commercial Overdraft is still around 7% and more secured against business assets. The OCR is 1% and clearly has little or no effect as the gap between the OCR and actual business related loans are wider than it has ever been.

    Credit liquidity is being artificially interfered with by the RBNZ through its equity restrictions on LVR and responsible lending rules. No matter how low you drop the OCR if credit liquidity is being restricted than real interest rates will continue to be high.

    Liked by 1 person

    • Not engaging on your first para/sentence (we’ve been there before), but I have some sympathy re the second para. The other relevant factor is the new much-higher bank capital requirements, which will be constraining credit availability unnecessarily (and as they were warned last year).


  2. RBA just cut its rate 25 basis points. They agree with you perhaps, although 25 points isn’t aggressive in my book.


    • It is a start and they do now have an explicit easing bias. They’ve gone public with their view that 25 bps is the effective floor for the cash rate, so to have gone further today might have immediately posed questions they may not yet be ready to answer.


  3. The trouble with aggregate debt is the difficulty of reducing the stock. Repay via income, sell assets, issue an equity instrument, or default/write-down all work in the individual case but not for the community. Which is why any government will eventually do ‘whatever it takes’ to make sure debt deflation doesn’t happen. That political/public will for fiscal support – even via direct central bank financing- could very easily change given the current threat is the health of people rather than concerns over the need for healthy balanced books.


  4. I agree with your core view. I think In both Australia and New Zealand monetary conditions have been too tight for years; a view I’ve expressed since 2012 and one that’s proven to be quite profitable.

    But I am not convinced that monetary policy is going to be very effective against COVID-19. If the issue is a crisis of confidence – and medical issues – cutting interest rates will have essentially no impact as the scale of the supply response will be overwhelming. There is a strong case for maintaining easy liquidity conditions – to ensure market function remains orderly – and if credit conditions start tightening a case for easing exists.

    But what we are seeing is a political response by a US President who has seen the correlation between his electoral odds and stocks and has conflated correlation with causation. The real reason for his re-election odds to have risen was a strengthening economy, not higher stock prices.

    Meanwhile, the actions of Central Bankers have effectively primed the system for another collapse in stock prices. Stock prices should be lower. Earnings will be lower, earnings expectations are more uncertain and valuations are high. Policy makers have all-but eliminated short open interest in stocks, put-call ratios show markets were extreme and the BTFD crowd get constant reward for moral hazard.

    Stocks have only fallen to levels of late last year but from the behaviour of the financial community, anyone would think a financial calamity had befallen us.

    Manipulating markets and not allowing market forces to operate is priming the system for a rupture.

    Liked by 1 person

    • Economists core view is just completely wrong. In terms of numbers of people we have more savers than borrowers. Total NZ Household debt almost equate to NZ Household deposit savings. More cuts actually cut spending confidence by physically more savers.

      The largest effect that interest rates cuts have is on business borrowings rather than household borrowings. But businesses in this current climate cannot respond to interest rate cuts. There is just no capital investment or customer operating product to buy whilst China is still shut down.


    • Thanks Peter. I don’t think I really disagree with you, and certainly don’t think mon pol easings now should be primarily (or at all) about falls in share prices, esp (as you note) how close to historic highs we still are. Also agree mon pol won’t make much difference in the midst of the crisis. My argument – as in the post – is mostly about the medium-term, getting conditions in place early to (a) support recovery, and (b) limit risk of a sharp sustained fall in inflation expectations. However, there is another argument: the price-stability consistent interest rate is now – perhaps temporarily – much lower than it was, and generally mon pol should adjust in line with such changes.

      In addition, there are probably going to be substantial losses of income that are never made up (we will get back to previous track for GDP in time, but what doesn’t happen this year won’t ever happen. That income loss will be allocated somehow, and I think a natural component of that would be a lower debt servicing burden (and lower returns to depositors – the time value of money is really is lower at present).


  5. Waste of time talking about interest rates.
    The issue is that the world has stopped trading.
    Doesn’t matter what the rates are if there is no cash in the till the money can’t go round.
    Already we have lots of people with no work on a daily basis.
    We are not getting all the stuff made in China and today half the house is.
    Tradies can’t get the gear they need, stores are running out of stock.
    No computers for retailers to buy, heat pumps and parts in short supply, bathrooms, showers some brands of ovens sold out, car parts running out, the list goes on.

    And then there are exports. Containers are piling up on ships around the world because no one wants to handle them.
    We are a service business with 10 staff.
    I monitor the traffic to my website on a daily basis and in the last 2 weeks, it has crashed. ( A series of big lotto’s doesn’t help), but what next?
    What do I do with my staff that I need to pay when there are no jobs coming in to create the income?
    Even if the bank charged me no interest there is still no money to pay the bills and anyway the amount I pay is negligible.

    Govt. can’t spend enough money to stop the rot.
    Govt. produces next to nothing and trades nothing more than currency. There is no solution there.
    Lowering the rates will benefit those able to negotiate them but for those on fixed, that’s not doing anything.
    Even if the ability to spend is increased by that small margin, supplies are running out and if it continues then there will be no schools, sports, going to work, you see the scenario.
    Do we have the capital and ability to suddenly start producing all these things again immediately?

    So it’s going to get tough.

    I’ve got a couple of reasonably new hot water cylinders I can sell a builder for a house. Might be the best he can do.

    Liked by 2 people

    • Yes, that lack of goods due to the disruption of our supply chains is the problem this time; not sure what monetary and fiscal responses can do to help that. The seeds of stimulation will fall on barren ground.
      I don’t fully understand why goods are not getting produced and distributed but with our complex, interconnected global supply chains this is a very serious issue. Car plants are closing for lack of a few components. Building projects here are being suspended or seriously delayed for the same reasons.
      President Trump’s moves to encourage more independence and American industry is looking like a very good idea.


      • I agree. It is actually rather silly to be talking about interest rate cuts. You need savers to go out there and keep spending rather than restrict their spending as well. I am dumbfounded that economists have zero reality grasp of their own economic tools.

        Borrowers do not need more interest rates cuts because the Equity restrictions on LVR and responsible lending rules prevent them borrowing more to spend up anyway. Lower interest rates can’t help borrowers when there is a RBNZ credit squeeze still in place.


    • THanks for that perspective. On the role interest rates can play see my response to Peter above, but yes I totally agree that int rates don’t make very much difference in the midst of a looming crisis, but the exchange rate is a not-unimportant consideration esp for firms who are still exporting, and we should be doing what we can to get it down fast for the duration. The beauty of monetary policy is that it can be quickly reversed if we emerge from all this with robust demand again.

      Other measures are almost certainly needed, but they need to be chosen wisely, partly because things here could – quite probably will – get a lot worse here before they get better.


  6. Reblogged this on The Inquiring Mind and commented:
    This repi venture to suggest that our government will not take necessary action, but will be reacrive, not proactiveays some focus by the reader especially if you are not an economist, which I am not.


    • I apologise something went wrong with my typing, it should read

      ‘This post repays some especially if you are not an economist, which I am not. I venture to suggest that our government will not take necessary action, but will be reactive, not proactive’.

      Again my apologies


  7. I distinctly remember sitting in front of my screens reading about a USD $500 helicopter money drop and the story of a young lady living in New York who used it to take a holiday in Bermuda – it was either Y2k time or dot-com-bust time or September 2001 or GFC time – can’t remember – trying to research who did it and when – but can’t find a thing – it did happen – but it seems to have been rubbed out of existence

    Then there was TARP, the buying of risky troubled assets off the big-end-of-town

    Researching it yesterday – yep the residue is still outstanding – it is still floating around and hasn’t yet been completely redeemed (reversed)

    The 3 QE programs are still outstanding on the Federal Reserve’s Balance Sheet – all designed to prevent a catastrophic collapse of asset prices held by the big-end-of-town – we might well wonder why asset prices are still hanging high – the cost of doing so has been lower and lower interest rates

    Trouble is this time round the FED has nowhere to go should the asset-price collapse begin


  8. Been out and about town in Taurnaga today.
    There are no trucks doing anything.
    Really no trucks.
    Usally there are one after the other.

    Very serious stuff.


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