As volatile share markets have fallen around the world in recent weeks, central banks are once again faced with the question of how to stabilize the financial markets. Unlike the crisis in 2008, current market volatility is not due to worries about the creditworthiness of private borrowers and their impact on financial institutions. The situation today is partly a consequence of the fiscal policy actions taken by governments in 2008, and partly the inability of central banks to bolster confidence and stimulate lending. Governments ran up large deficits when they lent to financial institutions to prevent a financial collapse and to bolster aggregate demand in order to prevent economies from sliding into depression. At the same time, steps were taken by national governments and international institutions to try to strengthen the viability and stability of the international financial system.

The policy measures implemented in 2008-09 stemmed the collapse in confidence and provided some degree of economic recovery in the advanced economies, although, as we can clearly see now, that recovery was fragile. The weak economy and the domestic stimulus measures undertaken resulted in a large increase in government deficits and debt. In some countries, a weak economy and low taxes have meant that government revenues are low, but expenditures on payments to the unemployed and other safety nets remain high, resulting in a further rise in deficits. Raising taxes and reducing expenditures is likely to only further lower the growth rate in the current financial situation, which means we are not likely to see a reduction in deficits, nor in debt/GDP ratios.

After the major stimulus spending of 2008-09, central banks have limited monetary tools at their disposal for reviving the economy. Central banks conduct monetary policy by buying certain assets, which is intended to improve liquidity and catalyze lending. By buying assets from financial institutions, central banks provide financial institutions with the money they need — the liquidity effect. Through interventionary action, a central bank can prevent financial institutions from being forced into a “fire sale” of their assets, which, in turn, worsens their balance sheet and leads to a loss of confidence in markets.

By improving the liquidity of these assets, the central bank is hoping to make them more attractive to encourage other financial institutions to purchase them. This is tantamount to lending to the financial entities that are issuing the assets. Interventions by central banks in response to the crisis of 2007-08 were effective in meeting the liquidity needs of financial institutions and, in many cases, halted the fears of bankruptcy. However, central banks were not able to get these institutions to actually lend, given that repayment remained uncertain as long as the economic recovery remained weak.

We now have a situation where banks have large amounts of money, but are not willing to lend. Interest rates — which central banks influence strongly — cannot be lowered further to stimulate more growth, given that rates are already close to zero. Central banks have also tried to intervene by widening the class of assets they are willing to buy and they could try to further enlarge this class of assets. However, financial institutions will likely continue to hoard money and not lend, due to continuing weak overall growth, perpetuating the vicious cycle. Central banks are, therefore, constrained in terms of the support they can directly provide to stimulate the weak economies in the current environment. The need to get financial institutions to lend again lies at the heart of the problem; it is the only way to restore growth to economies.

Policy makers also face a serious dilemma, in trying to employ fiscal policy. This dilemma partly reflects a trade-off between short-run and long-run goals. In the United Kingdom, the government has cut expenditures and raised taxes in an effort to reduce the deficit and the debt/GDP ratio; governments in Canada and the United States are set to do the same. But, as noted above, cutting expenditures or raising taxes would definitely lower the GDP and may worsen the deficit. Financial institutions are worried about how deficits and the debt/GDP ratios are affecting overall growth, but they are also worried that fiscal measures being adopted by governments will not necessarily lower deficits or the debt/GDP ratio. This dilemma explains both the decline in stock markets and the volatility. The most viable way to reduce the debt/GDP ratio is to aim for the long term and raise the GDP through faster growth. In the past, countries have achieved this by increasing exports, as higher exports help to increase the GDP and lower the debt/GDP ratio. However, raising exports will be difficult in the near term, with all countries cutting expenditures while at the same time, many advanced economies are trying to increase exports.

Monetary policy has proven relatively ineffective in raising the level of economic activity as financial institutions did not increase their lending, and further easing of monetary policy is unlikely to bring a different result. This means policy makers are now left, by and large, with fiscal policy tools, even though investor fears of high deficits and rising debt/GDP ratios continue.

To make fiscal policy work in such a scenario requires coordination between both treasuries and central banks, and across other related government agencies. Coordination between treasuries and central banks can prevent a negative reaction from financial markets to the increased fiscal stimulus. A negative reaction may be avoided if policy measures are also coordinated between countries, to ensure that major governments participate in sharing the burden.

Expansionary fiscal policy is unlikely to cause a rise in inflation in developed economies, and even if that were to happen, it might be a risk worth taking in the current circumstances. However, many emerging economies such as Brazil, China and India are already suffering from high rates of inflation and have been raising interest rates to curb inflationary pressures. While the developed countries (G7) could try to coordinate among themselves in undertaking fiscal expansion, it would be better if the emerging economies were involved in a more broadly coordinated approach (G20) to provide fiscal policy support. Emerging countries would want to calculate the relative risks of further slowing down the developed economies against the consequences of a higher rate of inflation.

Central banks would need to coordinate their interventions in order to limit currency fluctuations, which would compound the existing volatility in stock markets. This would require the central banks to agree on the appropriate set of exchange rate adjustments or at least an appropriate set of bands for exchange rates.

To further build confidence in the markets, governments need to draw up different scenarios for GDP growth, fiscal expenditures and revenues, deficits, and debts, so that markets can see the policy direction for the long term, and how policies could be adjusted depending on the actual outcomes over the medium term. This would provide greater certainty on the viability and sustainability of fiscal policy over the long run.

A coordinated response from treasuries and central banks and across countries is needed to tackle the current situation. The response should not separate short-term restabilization from longer-term structural measures. Both have to be tackled simultaneously through a coherent plan that can give confidence to markets — a road map that integrates macroeconomic policy and fiscal and exchange rate policy adjustments, which will require domestic interagency and international coordination.

 

 

We now have a situation where banks have large amounts of money, but are not willing to lend.
  • Manmohan Agarwal

    An experienced practitioner and scholar of global trade policy and economic governance, Manmohan Agarwal joined CIGI as a senior visiting fellow in 2008, following a long career at Jawaharlal Nehru University in New Delhi, India, the International Monetary Fund and the World Bank. His current research focuses on the growth of emerging economies and their role within the world economy and international development.

The return of market volatility has shaken the confidence of a fragile recovery. How are leading economies responding? Is the current turmoil giving way to another free-fall in global markets? Are the international governance mechanisms, established after the last crisis, up to the task of averting another crises? What can the major powers do? In this timely commentary series, CIGI experts examine these key issues, and offer recommendations for policy makers looking to restabilize the world economy.