October 12, 2021
  • October 12, 2021

Power shift in the global economy

By on October 11, 2021 0

The COVID-19 pandemic has caused a huge shock to the global economy, just as we are witnessing a major shift in economic management decisions.

It’s a change that could leave central banks on the sidelines as we navigate the economic impact of COVID-19, leaving governments firmly in the driver’s seat.

The economic shock of COVID-19 in a period of persistently low interest rates means that national governments are now the key players in managing economies. Image: Getty Images

And that could mean a new political focus on reducing unemployment to levels not seen in nearly 50 years.

A look back at history shows us that the standard economic toolkit of recent decades has relied on monetary policy – raising or lowering official interest rates – conducted by central banks to stabilize the economy. In most rich countries, the central bank makes these interest rate decisions independently of the government.

In practice, central banks manage the interest rate so that the economy is neither too hot nor too cold.

During a downturn, central banks can reduce the interest rate to encourage lending to persuade households and businesses to increase spending. In good times, they can raise interest rates to curb spending and keep inflation from rising too high.

In contrast, governments try to manage the economy using fiscal policies such as reducing or increasing taxes and reducing or increasing public spending.

But fiscal policy has long been out of fashion, in large part because of the perceived success of central bank monetary policies. Indeed, such has been the success of monetary policy, that Nobel Prize-winning economist Robert Lucas said in 2003 that “the central problem of preventing depression has been solved”.

Monetary policy based on adjusting interest rates is a key tool of central banks in managing economies, but it has been rendered ineffective by persistently low rates Image: Unsplash

However, not all economists were convinced – as we rarely are – but in practice that hasn’t changed much. Until recently.

The GFC and the first cracks

Interest rates had been falling for a long time when the global financial crisis hit in 2007, followed by the European debt crisis a few years later. This has left most of the central banks in rich countries struggling with extremely low interest rates.

The result has been that monetary policy has lost most of its effectiveness, as interest rates close to zero leave no room for further cuts by central banks keen to pull their economies out of recession.

One by one, central banks have had to resort to unconventional monetary policies, what economists call quantitative easing.

Initially initiated by Japan, these policies consist of buying government bonds and other financial assets, which injects money into the economy and increases the value of assets and therefore, potentially, investment and l ‘inflation.

However, this is not as effective as reducing the interest rate, and it also increases wealth inequalities as it increases virtually all asset values, leaving those who cannot afford these investments to miss out. .

The global financial crisis, symbolized for many by the collapse of the investment bank Lehman Brothers, has left central banks crippled by low interest rates. Image: Getty Images

In the years since GFC, we have witnessed frequent and unprecedented calls from central banks for fiscal policy to do more. Oddly enough, this means central bankers are calling for larger government deficits, even at the European Central Bank in Frankfurt, a stronghold of conservative policymakers traditionally wary of public debt.

COVID-19 and the rising tide

Central bankers understood that if governments didn’t implement expansionary fiscal policies – like tax cuts or spending increases – to boost economic growth and inflation, they couldn’t get out of this world of poverty. low interest rate. This would therefore leave them largely powerless during the next economic shock or crisis.

The next crisis turned out to be a global health pandemic, and it is no small crisis. In many ways, this is an unprecedented crisis in its scale and the large number of countries affected at the same time.

Most governments realized early on that massive injections of cash to businesses and households were needed to help them weather the looming recession.

To the surprise of many, the governments of rich countries have had no difficulty in financing their large budget deficits and, despite the increase in public debt, interest rates have remained low.

The pandemic has shown that fiscal policy can do more to fight recessions than has been achieved in recent decades. But what has become clear is not only that fiscal policy can do more, but also that it should do more because monetary policy is largely ineffective in a world of low interest rates.

Australian Treasurer Josh Frydenberg’s about-face on budget deficits is emblematic of the evolution of economic thought. Image: Getty Images

This is an important political development that can take us to a new world. The reason is that central banks and governments have different priorities.

A NEW OLD PARADIGM

Central banks have focused on controlling inflation. In fact, inflation has been so well contained that major central banks have consistently failed to meet their healthy inflation targets.

Governments, on the other hand, tend to place more emphasis on keeping unemployment low. Given the new consensus that governments have a renewed and greater role in stabilizing the economy, they could lower unemployment rates to single-digit levels as they did before the mid-1970s.

This sudden shift in mindset helps explain how Australian Treasurer John Frydenberg shifted from focusing on restoring a budget surplus to promoting expansionary fiscal policies to bring down unemployment.

And Australia is not alone.

The same change is clearly apparent in the United States with President Joe Biden’s major spending programs.

This renewed focus on fiscal, rather than monetary, policy to manage the economy could run deep, hopefully producing a policy mix more likely to boost employment and, in so doing, reduce economic inequality.

Banner: Getty Images