On the ninetieth birthday of Milton Friedman, Nov. 8, 2002, Ben Bernanke, future chairman of the U.S. Federal Reserve, made a remarkable admission. Analysing the myriad causes and consequences that led to the Great Depression of 1929, Bernanke admitted that the actions of the Federal Reserve fuelled panic and aggravated the pain and duration.
Endorsing what Friedman and Anna J Schwartz had stated in their seminal work, A Monetary History of the United States - Bernanke said “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
When the monetary history of the new millennium is authored, by the latter-day avatars of Friedman and Schwartz, the actions of the Federal Reserve in March of 2020—amidst the spectre of fear triggered by the Covid-19 coronavirus—will be interrogated. A century after ‘the great contraction’, and almost two decades after Bernanke’s confession, the Federal Reserve had done it again.
Prima facie, the U.S. Fed tipped into political cuckoldom following the persistent criticism by the U.S. President and fuelled fear in the markets.
The Fed’s action, of cutting interest rates, by 50 basis points, and then 100 basis points within days, exacerbated panic and accelerated flight of capital.
What is curious is that despite recurring ifs, buts, ambidextrous signals and about turns of the U.S. Federal Reserve in the past year, global central bankers—barring a few—continue to be invested in the wisdom of the Federal Reserve Board and also followed suit with cuts and this had a multiplier effect in the decline of value on bourses across the world.
The rate cuts, timed as pre-emptive steps to boost confidence did exactly the opposite – they were followed by precipitous fall in the equity markets and bond yields.
Vulnerability to the virus or financial stress is dictated by pre-existing conditions. The high level of leveraged debt of enterprises was funded by commercial lending and private equity barons, with companies riding notions of valuation with scant regard to margins or revenues.
The moment called for bolstering availability of funds whereas the Fed was haunted by notions of affordability.
In a landscape where lending had come to a virtual halt, the sequencing of the Fed’s actions propelled the crisis of confidence and solvency.
During the 1987 crash, which is the reference point for stock market crash comparisons, the Federal Reserve issued a one-sentence press release: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” The focus was liquidity and interest rate cuts followed to enable it.
In the chapter on The Great Contraction, Friedman and Schwartz concluded that the prevention of a decline in the stock of money would have lessened the severity of the contraction and its duration.
The Structure Of The Crisis
To appreciate one needs to look at crisis structurally – the causation and the consequence. The paramount concern is to quell the transmission of the virus and the spread of illness. This, administrations have concluded, demands flattening the curve of infections. This quest to flatten the curve results in the deepening of the economic impact.
The need for social distancing has resulted in disengagement of people and economic activity. The shutdown of travel, tourism, transportation, bars, cinemas, and restaurants across the world paralyses segments of the economy. The breakdown of the supply-demand chain triggers collateral consequences – fall in demand for services provided by airlines or tour operators or restaurant owners as also goods and for fuel and energy.
The consequence of the shutdown on the real economy is the causation for financial markets to react, eroding value in response to the threat of falling revenues and losses. Global stock indices have slid by over 30 percent from their peak and many bond yields are yo-yo-ing around zero.
The consequence on the financial markets morphs as causation once again on the real economy.
The fall in stock valuations threatens enterprises in India whose promoters have pledged shares to borrow, and in the U.S. over-leveraged companies and zombies. And the spectre of collapse, potential job losses, and loss of wealth effect combine to aggravate panic.
It is unsurprising, in a sense, that the Philippines government shut down the stock market and that there is talk shutting down the stock markets elsewhere, along with a suggestion by U.S. Treasury Secretary Steve Mnuchin about shorter trading hours. The notion behind these is to curb bad news!
Desire, Ability, Willingness And Opportunity
Now juxtapose the Fed rate cut—and those by a parade of central banks—into this context. Theory says lower cost of capital can nudge consumption. But like all laws of economics, this contention is subject to the caveat of necessary and sufficient conditions. Studies show that availability and affordability factors are subject to the statute of limitations.
Consumption is defined by desire, ability, willingness, and opportunity. Ostensibly many in San Francisco, Mumbai, Madrid or Seoul desire to consume. The next critical point is whether they are able – do they have the discretion or surplus to pay? Perhaps they do. The question then is about willingness – would they spend or stack cash in the face of uncertainty? Assuming they are desirous of binging, able to pay for big tag acquisitions, and willing to spend... but what about opportunity?
At another level, the corporate level, the lower cost of capital could be enticing for those seeking to set up a new business or expand. The question is whether the investment is stranded or expansion stalled due to the cost of capital. Obviously, decisions to borrow are determinations based on the potential for returns. Why would an entrepreneur set up a business or expand in the given circumstance of shutdown and collapse of demand?
The questions are particularly relevant for emerging economies.
For India where there is a similar clamour for a cure-all interest rate cut – it doesn’t seem to matter that a series of rate cuts have not quite lifted the tide or the boats. Fact is, a combination of stalled structural reforms at the state level and fiscal profligacy is stalling growth. As the cliché goes you can only push the string so far.
King Canute And The Waves
The parable of King Canute and the waves serves as a useful metaphor to symbolise the politics of economics. There is an embedded belief that monetary policy has the fix for curing the real economy.
In the parable, the King is urged by the people to stop the waves and of course, he cannot. In the modern world the heads of state, political executives would like central banks to similarly stop the wave of bad news. Obviously, they flail and fail just as King Canute did.
There is little evidence to back the need for rate cuts and/or its efficacy to protect savings from vulnerability and counter volatility in the financial markets.
As Robert Skidelsky noted, “fiscal policy might in principle be up to the task of economic stabilization, there is no chance that central banks will be.” Worse, the sequencing of the action, the rate cuts followed by quantitative easing, left the Fed without bullets.
Criticality Of Stability And Certainty
Economic certainty is essentially about ensuring the tedium of normalcy. Certainty will require news and information on the containment of the virus, the lifting of curbs and this will take time and will arrive on the heels of news on ways and means, innovations to deal with the virus.
Meanwhile, life must go on. This calls for maintenance of monetary stability which translates into the actions proposed by the U.S. Fed finally – readiness to fund the purchase of bonds and commercial paper to preclude systemic risks. The quest also demands fiscal policy action to design buoys to save those drowned by the tide. Unlike the past subscription is veering away from helicopter economics of the universal basic income kind to direct transfer of income support to those affected by isolation or quarantine and those laid off.
It is said that markets can stay irrational longer than institutions can stay solvent. So, like in any relationship, injecting and ensuring stability and certainty is critical for economic sustainability.
Shankkar Aiyar, political-economy analyst, is the author of ‘The Gated Republic – India’s Public Policy Failures and Private Solutions’, ‘Aadhaar: A Biometric History of India’s 12-Digit Revolution’; and ‘Accidental India’.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.
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