As the impact of the Covid-19 disaster unfolds, the politicians and central bankers did not want to be caught napping. They unleashed a stimulus package that makes the 2008 Global Financial Crisis look like a b-rated warm-up act. But will there be unintended consequences?
Historically, Central Banks used the adjustment of interest rates as the main lever to stimulate the economy. As the economy grows too fast, and fears of inflation were emerging, central banks put the brakes on by increasing interest rates. And when the economy falters, they released the brakes again by reducing interest rates. That worked to some degree. Lower interest rates encourages companies to borrow money and invest it, while higher interest rates did the opposite. Central banks are not the only ones able to stimulate the economies, politicians can do it too. However, politicians generally have a noticeably shorter time horizon. Central bankers could afford to act independent and look at the long term.
Policies before the 2008 financial crisis were primarily focused on keeping inflation low. Inflation destroyed a recovering Germany in the early 1920’s and wreaked havoc across the world in the 1970’s. From the 1980’s onward most developed countries and more and more emerging countries began to control inflation by a combined effort of fiscal prudence and monetary restraint.
The war on inflation was seemingly a fading memory by the time the 2008 global financial crisis hit. But since the political response to the crisis was underwhelming, it was up to Central Bankers to come to the rescue. They lowered the interest rate to almost 0%, and where then seemingly running out of ammunition. That’s when the Fed Chairman Ben Benencke announced that the Fed will use their balance sheet, which in US Dollar terms is essentially unlimited, to buy US government bonds across the yield curve.
This would help in two ways. Firstly, the interest rate would stay low and the government can borrow as much as they want at low rates. Secondly, since they would buy bonds on the secondary markets ie from investors like banks and insurance companies, they would inject a lot of cash into the system. The cash could be used to invest in other projects.
Some investors with good memories were wary. Surely the increase in money supply would cause inflation? Not so. Since 2008, most developed markets were struggling to avoid deflation. Inflation is like red wine. You would want a glass a day, but a bottle is detrimental to your health. Economies do well when inflation is at about 2%, poorly when it is when it is below 0% and even worse if it is above 10%. It is the fastest way to lose the value of money, just ask any Zimbabwean.
Inflation has been the least of most economist concerns for years. During the early 2000 the rise of China because of their low cost of production has been a counterweight to stagnant wages in America and rising living expenses across much of the developed world. After the financial crisis, the excess spare available production capacity coupled with the efficiencies gained by better use of the internet and an ever better integration of high tech in normal production (like using robots in car assembly and drones to detect crops that need more attention for a higher yield) has kept a lid on inflation.
In effect of the Covid-19 crisis was truly unprecedented. In the last week of March, the weekly jobless claim was 6.8 million. Previously the weekly jobless claims in the USA reached about 600 000 during times of crisis. The US Federal Reserve Banks response has been equally dramatic. They started buying bonds again at an extraordinary pace. The effect on their balance sheet has been 3 times larger than during the global financial crisis of 2008. This has been met with the responses of the European Central Bank, the Japanese Central Bank and even some emerging market central banks. The politicians have also been much quicker to respond. Altogether, the response to the crisis has been more than 9 trillion US Dollars.
The difference to the financial crisis though is that this enormous injection of cash has not been met with a corresponding destruction in capital. During the global financial crisis of 2008, home prices collapsed and many property developments across the globe were abandoned because the developers went bankrupt. The glut of homes on the market meant that prices stayed low for long and investment bank in the USA had to raise about U$ 300bl to fill the holes one their balance sheets.
This time it is a crisis in the lack of income, because so many economies were shut down. It has (not yet) led to a destruction of capital. Even though we probably won’t see the same record profits generated this year, the global total wealth (capital and income) has increased by the stimulus packages and therefore we could see a consistent upward pressure on inflation, maybe not now but probably in 3 years’ time.
While it is right to focus on retaining the livelihoods of everyone affected by the epidemic, it is prudent to keep an eye out for potential unintended consequences, especially when one of those is inflation.