As the economy hit the nadir of the global financial crisis at the turn of 2009, an American economist teamed up with a production company to produce a video called: Fear the Boom and Bust — Keynes vs Hayek.
But rather than an erudite series of lectures, the message was delivered through the medium of rap. “Keynes” argues his case for governments to borrow to spend in the face of recession: “If the central bank’s interest rate policy tanks/ A liquidity trap, that new money’s stuck in the banks/ Deficits could be the cure, you been looking for/ Let the spending soar, now that you know the score.”
In real life the Keynesians won the first round as the leaders of the Group of 20 (G20) countries found $1tr at their April 2009 summit to inject into the International Monetary Fund while governments of the United States and China embarked on multi-billion stimulus programmes.
But the scale of the eurozone crisis that began the following year enabled Hayekian monetarists to persuade finance ministers to cut spending in order to reduce budget deficits and let interest rate policy take the strain.
As interest rates were cut to close to zero in the US, the UK and the eurozone, policymakers hoped cheap money would finally encourage business investment. When it did not, countries such as Japan, Sweden and Switzerland imposed negative interest rates in the hope that banks would lend money rather than pay interest to the central bank.
According to Chetan Ahya, global co-head of economics at Morgan Stanley, central banks have been burdened with increasingly complex challenges in managing what he calls a “unique” global economic cycle thanks to a pronounced deleveraging cycle, falling productivity growth and worsening demographics.
“Central banks have found themselves unable to cut real interest rates via traditional monetary policy tools to an extent that would stimulate the economy,” he says.
And with the IMF yet again cutting its outlook for global growth at this week’s annual meetings, economists are debating whether by cutting interest rates further central banks are — to use Keynes’ phrase — “pushing on a string”.
Larry Summers, professor of economics at Harvard and a former US treasury secretary, coined the phrase “secular stagnation” — a new long term era of negligible economic growth. A Keynesian economist, he advocated a repeat of the co-ordinated policy response seen in 2009 at the September summit of the G20 in Hangzhou, China.
IMF managing director Christine Lagarde echoed the call saying interest rates were “increasingly stretched” and that it was time to loosen fiscal policy again. “Record-low interest rates make for an excellent time to boost public investment and upgrade infrastructure,” she said.
HIGH QUALITY INVESTMENT
In the end, Hangzhou offered no headline grabbing initiative but opened the door slightly to fiscal policy, saying that monetary policy alone could not deliver balanced growth.
It said members would use fiscal policy “flexibly and [make] tax policy and public expenditure more growth-friendly, including by prioritising high quality investment”.
“With central banks having almost run out of ammunition, there may be more focus on fiscal policy in the coming years,” says Andrew Kenningham, senior global economist at Capital Economics, who expects a “small” fiscal stimulus over the coming two years.
In the meantime, some economists are getting worried about the impact of ultra-low interest rates on financial markets — and for what will happen when central banks finally start to raise rather than cut borrowing costs.
Ahya at Morgan Stanley says that in the early stages of the current recessionary cycle, central banks that engaged in quantitative easing helped to calm markets and bring about a reduction in interest rates.
However, as policymakers rolled out ever more complex and unconventional measures he says that “scepticism surrounding the effectiveness of monetary policy” has increased. “Central banks have now emerged as a source of uncertainty,” he says.
The main negative impact of unconventional monetary policy, including the use of negative interest rates, has impacted on the profitability of the banking system. Claudio Borio, head of the monetary and economic department at the Bank of International Settlements, says banks have “appeared to struggle”.
The prospect of lower rates for longer has raised serious concerns about banks’ profitability, he says, as ultra-low rates and flat yield curves erode their net interest margins and reduce the cost of carrying non-performing loans, in turn delaying the necessary clean-up of banks’ balance sheets.
At the same time ultra-low rates have fuelled a boom in asset prices across a range of sectors: equities, bonds and property have all seen sharp spikes. It has also encouraged a familiar search for yield leading what Borio calls “the usual signs of exuberance”.
This is beginning to cause headaches for central bankers who have to deal with an asset price surge that is the result of their being handed the lone job of boosting growth.
For the moment, talk of fiscal stimulus is exactly that — confined to academic circles and newspaper columns. But that could change, Ahya says. “As central banks continue to struggle in lifting aggregate demand and achieving their inflation targets, the persistence of this could move the dial on fiscal policy,” he says.
But while policymakers will probably be tempted to turn the dial up on fiscal policy especially ahead or after elections in France, Germany, the UK and the US, they are unlikely — to borrow from the film Spinal Tap — to turn the volume up to 11.
Particularly in the eurozone, policymakers should have memories of the near collapse of the eurozone amid fears that Portugal, Ireland, Italy, Portugal and Spain (the Piigs) could all go bankrupt seared on their brains.
These concerns explain why the G20 held back from calling for a full throated fiscal expansion saying that members would “enhance resilience and ensure debt as a share of GDP is on a sustainable path”.
However, there are signs that as the eurozone debt crisis moves into the history books, those memories start to fade. The eurozone’s commitment to austerity has “waned”, Kenningham at Capital Economics says.
“Budget deficits in the southern economies have narrowed substantially, reducing the urgency for further cuts,” he says. “And the European Commission has, with Germany’s blessing, taken a lenient attitude towards excessive deficits in Italy and Spain.”
Heirs to Hayek worry that if the spigots of public spending are opened, central banks may have to raise rates to combat any rise in inflation, a fear that has not been much in evidence for the past few years.
The particular bind that today’s central bankers face is that investors have got used to the endless supply of near-free liquidity, and that even a small hike in interest rates could trigger a market crash that would offset any positive impact from fiscal policy.
Olivier Desbarres, a consultant and former investment bank strategist, says that central banks are nearing an important “inflection point”. “If anything, financial markets will become more sensitive to any downturns in still tepid global growth and inflation and to the negative side effects of loose monetary policy,” he says.
The Dow Jones stock index fell by 2.1% in the first two weeks of September in the wake of a warning by Fed chair Janet Yellen in her Jackson Hole conference speech that the case for an increase in the federal funds rates has strengthened in recent months.
In the end a run of disappointing data and mixed messages from other Fed members ruled out a hike at its monetary policy meeting a week later on September 21 albeit on a split decision.
But markets are also nervous about a fresh bout of Keynesianism in the UK and in the US after President Obama’s $800bn American Recovery and Reinvestment Act.
BUILD IT AND THEY MIGHT COME
One area that has been seized on by politicians on both the right and left is infrastructure investment. Both the candidates for leadership of the UK’s Labour Party called for an injection — £200bn by Owen Smith and £500bn by the eventual winner Jeremy Corbyn. Prime minister Theresa May is expected to shift spending towards infrastructure while abandoning a commitment to balance the UK budget by 2020.
In the US Hillary Clinton has proposed a $275bn five year plan while Donald Trump has gone big — calling for $800bn-$1tr of spending on roads, bridges, energy grid and water systems.
Its advocates say financial markets will treat long term debt taken on to fund productive investment in a more benign way than borrowing to fund day-to-day spending.
However, some commentators believe that debt is debt however it is categorised. In the UK the Labour government in the previous decade even devised a fiscal rule that excluded investment spending from how it calculated the budget balance — an analysis that looked embarrassingly irrelevant once the crisis struck.
In the US, the non-partisan Committee for a Responsible Federal Budget (CRFB) estimates Trump’s plans will see federal debt rise to 127% of GDP by 2026 from 74% last year. It estimates the net effect of Clinton’s proposals will raise the federal budget deficit to 87% of GDP by 2026.
“As advocates of expansive fiscal policy are wont to do, [Trump] assumes that the economic growth these steps could generate would boost tax revenues and help limit any increase in the federal budget deficit,” says Stephen Lewis, chief economist at brokerage ADM ISI.
Trump has used his campaign to shift Republican thinking away from smaller government and supply side reforms that have dominated the party since the war.
“Republican thinking had been dominated by pro-market enthusiasts such as Hayek,” he says. “The era of such ideas holding sway in Republican circles may be approaching its twilight.”
In an unlikely meeting of minds, IMF managing director Christine Lagarde has again called for a shift in the fiscal and monetary policy mix. In a speech in late September she said central banks had done the “heavy lifting” in recent years, adding: “Now fiscal policy needs to play a bigger role in countries that have additional spending headroom.”
But the idea of a co-ordinated shift in the policy mix is unlikely to be unveiled at this week’s annual meetings especially in face of resistance from debt-phobic Germany that blocked any idea of a G20 stimulus.
“The IMF is not important enough to dominate domestic political debate in Germany on how much they should spend and whether taxes will be cut,” says Holger Schmieding, chief economist at German bank Berenberg.
As “Hayek” sings it in Fear the Boom and Bust, “Your so-called “stimulus” will make things even worse/ It’s just more of the same, more incentives perversed/ And that credit crunch ain’t a liquidity trap/ Just a broke banking system, I’m done, that’s a wrap.”