When the pandemic hit earlier this year, policy makers around the world were swift with their responses. As at June 2020, they have provided a total of US $7 trillion in quantitative easing, US $6 trillion of fiscal policy, and US $4 trillion in loan loss guarantees. It’s a mind-boggling amount of money. But there’s no guarantee that even sums as vast as these will help the global economy avoid long-lasting and severe repercussions.

We take a look at which responses are most likely to be effective and how long the effects of the pandemic will be felt in our economy.

The dwindling impact of monetary policy

For several decades, monetary policy was conducted through manipulating cash rates. During the Global Financial Crisis (GFC), the Reserve Bank of Australia lowered the cash rate by a total of 4.25%. The typical cut in cash rates by the US Federal Reserve has been around 5% in past recessions. However, we’re now in an environment where cash rates around the world are at or near zero – so rate cuts can no longer provide the economic boost they once did.

As a result, most central banks have moved to monetary policy dominated by quantitative easing (QE). Over the past few months, since the pandemic began, QE has escalated, with central banks rapidly expanding the range of financial asset they are willing to buy.

Regardless of the method used, research shows us that monetary policy is generally more effective in the acute phase of a crisis, but less effective in the recovery phase after a crisis. However, history also warns us that our current low-rate environment is likely to hamper the effectiveness of any monetary policies executed by governments. There are two main reasons for this:

  • Hoarding of cash. Low interest rates can lead to individuals and businesses saving high amounts of cash instead of spending, which means the money isn’t being used to stimulate the economy.
  • Paying down debt. Post financial crises, individuals and businesses prioritise paying down debt instead of acquiring more assets through lending – even with interest rates at record lows.

Fiscal policy and government deficits

So what about fiscal policy? That’s where the good news comes in. While monetary policy may be less effective in our current environment, fiscal policy is likely to become more effective.

Since the GFC, fiscal policies have been relatively restrained as governments attempted to rein in their high debt levels. This is no longer the case. Even the most conservative governments are supporting their economies through the pandemic by aggressive fiscal spending. The focus is primarily on attempting to avoid businesses closures, minimising unemployment and reducing the hit from falling incomes. Unlike previous recessions, which focused on tax cuts and infrastructure spend, this type of fiscal spending can be implemented quickly for immediate results.

The outcome of all this unprecedented spending is, of course, government deficits. There are expectations of government deficits reaching 8% in Australia and 20% in the US, which is raising questions about whether this level of debt is sustainable.

There are four positive circumstances that should help economies manage their increased debt:

  • Contracting private sector. The fiscal policy is counter cyclical because it is occurring during a significant contraction in the private sector. This will limit the level of crowding out of the private sector and lead to the policy impact being highly effective.
  • Self-correcting policy responses. The job retention programs, liquidity lines, cash transfers and business loans are all temporary or one-offs, which makes it easier to return the deficits to more normal levels after the crisis is over.
  • Impacts on interest rates will be managed by QE programs. Any significant impact on interest rates will be managed by central bank QE programs, which will step in to buy the debt.
  • Low debt servicing costs. With interest rates near zero, debt servicing costs are extremely low.

If a country issues debt in its own currency, has a flexible exchange rate, and controls it central bank, excessive debt is not necessarily an issue.

The short, medium and long-term impacts

The pandemic will have a profound impact on the global economy, possibly for decades. With economies still suffering from the after-effects of the GFC, the pandemic will hinder growth and keep interest rates near zero. In this environment, monetary policy will be relatively ineffective, but fiscal policy will be a powerful antidote.

In the short term, the collapse in demand for goods and services will drive down inflation. While fiscal and monetary policy will reduce the negative economic impact, they will not be able to stop unemployment rates moving higher and will therefore not fully counteract the deflationary forces.

In the medium term, energy prices will likely add to inflation. The labour market will stabilise, and the unemployment rate will fall. The focus will move to how much the surge in liquidity, driven by fiscal and monetary policy, will impact on inflation. The ability to print money is not unlimited. At some stage the extra money will overwhelm the productive capacity of the economy, or foreign investors will lose faith in the currency. However, given the lack of effectiveness of monetary policy when interests rates are low, the amount of money printing now occurring is not expected to lead to an inflation problem, and inflation will continue to remain low.

We expect a large variation in how different economies will recover in the long term. It will partly depend on how successful each economy’s fiscal policy is in keeping a link between employees and their employers. More successful economies will have much lower unemployment once the pandemic passes and this will be due to effective fiscal spending. The other key factor is an early and strong pandemic response. Successful management of the pandemic in the early days will not only see a lower mortality rate, but also less structural economic damage and more robust economic recovery.

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David Lynch

Good commentary, await with interest the next

George Riszko

All based on the assumption that the virus will be controlled and we all go back to work. Can the economy survive if / when the second wave hits?

Sandy Shore

Interesting...printing enormous amounts of currency without a corresponding increase in goods and services will NOT cause inflation. I never did really understand economics, I guess!

ian boyd

Looks like the conservatives will have to resort to M.M.T. Sugest the treasurer get in touch with Prof Bill Mitchell or read his book Macroeconomics published 2019.

Raji Godbole

Interesting you say "Hoarding of cash: Low interest rates can lead to individuals and businesses saving high amounts of cash instead of spending" I thought it was the opposite! Why save if you don't get good returns? Instead, why not borrow when money is cheap and spend?