Tuesday 12 November 2019 4:03 am

Interest rates aren’t central banks’ only ammunition to defend against recession

Juan Castaneda is director of the Institute of International Monetary Research

Monday’s GDP figures were a mixed bag: the UK has narrowly avoided slipping into recession, but with growth at its lowest rate since 2010, the country is far from being out of the woods.

Nor is this just a British issue. Increasing numbers of economic commentators are sounding the alarm about a potential recession in the world economy in 2020. 

Furthermore, they claim that central banks would not have much room to manoeuvre. The argument is that the current (historically low) base interest rates leave central bankers virtually powerless in the event of a crisis.

Fortunately, they are mistaken. This view is based on the misplaced assumption that the only way money is created — and, thus, the only way a central bank can affect macroeconomic outcomes — is by the cutting of interest rates. 

But interest rate change is not the only policy tool available to create money. Indeed, nor is it the most effective in times of crisis. In modern economies, where monetary systems are purely based on fiat currencies, money can be created “out of thin air”. As shocking as it may sound, this means that central banks can always increase the amount of money in the economy.

We have evidence for how this can work. In the aftermath of the financial crisis, commercial banks were not able to create enough deposits (i.e. money) and boost lending in order to sustain spending. 

Under much tighter bank regulation, new liquidity and higher bank capital ratios severely diminished the ability of banks to expand their balance sheets. It was in this context that central banks had to act as the “suppliers of money of last resort” in the midst of the crisis. 

Through the quantitative easing operations, major central banks purchased public and private bonds both from banks and also from non-banks, which increased the amount of both bank reserves and, more importantly, deposits in the economy. 

Eventually, central banks managed to restore a stable level of growth of money in the economy. 

For how long and to what extent can central banks continue to buy assets in the market? The answer is that there is no limit — in other words, as much as is needed to maintain stable, moderate money growth. 

Stable and moderate money growth is an essential condition to preserve macroeconomic and financial stability. Too much money may lead to over-spending and inflation (Venezuela sadly provides a vivid example of what happens when no restrictions are in place), and thus usher in  the return of “boom and bust” cycles. But too little money in a crisis will only strangulate spending further, create deflation, and prolong the recession.  

In the event of another recession, if the ability of banks to take risks remains as constrained as it has been in the last decade, refusing to engage in quantitative easing would let the amount of money fall, aggravating the deflationary pressures. Central banks do not have to let this happen — they have the ammunition to tackle the next crisis, however low interest rates are.

The Institute of International Monetary Research is holding an event in conjunction with the Institute of Economic Affairs, entitled “Monetary policy vs. fiscal policy; which is best?”

Main image credit: Getty

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