Fscal and monetary policy

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For the first time since the Second World War the world economy is set for a recession. Amongst the backdrop of falling consumer spending, businesses and banks going bust, there is desperate need for major stimulus packages in the form of expansionary fiscal and monetary policy measures. This essay shall discuss some of the policies taken by three of the world's largest economies; the UK, US and Germany and evaluate to what degree they have been successful.

The first major country with a fiscal package was the US with a $168billion stimulus package, providing 117million US households with tax rebates. The hope was that consumer spending would increase, reducing any need for workforce cuts and encouraging economic growth. However, as can be observed by 1 it was not as effective as hoped, in fact a Goldman Sachs analysis [1] concluded that consumers only spent approximately 25billion of the rebates by June 2008. If this money was not spent it must have been saved which does not stimulate demand for goods and services. As illustrated by 2 personal savings rates did jump, from near 0% to 5%, when the tax rebates were conducted. Nevertheless statistics show that demand for nondurable consumption was boosted by 2.4%, and 4.1% in the second and third quarter of 2008[2] as a result of the stimulus payments.

Germany introduced two fiscal stimulus packages with a combined value of €81billion. These were mainly aimed at investment in infrastructure, schools, energy efficiency and implementing income tax cuts. 3 shows that this has been relatively ineffective, with economic growth and business confidence continuing to tumble. However, it has been argued that the stimulus package has helped increase economic activity, with growth increasing by 3.9% in Q3 of 2009.

In the UK VAT was cut by 2.5% from December 2008 to January 2010. The idea being that consumers would see durable goods as temporarily cheaper, bringing their spending forward and boosting the economy. However according to the Federation of Small Businesses 97% of businesses polled reported that this did not have a positive impact on revenue[3]. However given the economic climate it was inevitable that businesses would see revenue decline. Conversely a BBC poll[4] found that 23% of people had spent money they would not otherwise have done to take advantage of the VAT cut. UK retail sales have remained resilient during the recession particularly when compared to the US ( 1). Evidence suggests that VAT cuts have had a positive impact on the economy however its true value will become clearer as the VAT cut is removed.

Another fiscal measure taken by these three economies in response to the financial crisis was the “Car Scrappage Scheme”. Following the financial crisis, demand for cars declined dramatically. This scheme intended to boost consumer spending, increase demand for cars and support the car industry which is a major employer. The scheme gives consumers a discount when purchasing new cars, with policy variations across countries. In the UK, US and Germany it was conducted on a large scale with budgets of £300million, $3billion and €5bn respectively and has been seen as a great success. The White House estimated that the scheme saved 42,000 US jobs in the second half of 2009, and boosted economic growth between July and September by 0.3% to 0.4%. In the UK, “New car sales in Britain jumped by nearly a third last month (October), their biggest gain this year.” [5] “A total of 168,942 new cars were registered in October, up 31.6% from a year ago.” [6]Finally, in Germany, “The scheme has been very popular, driving German car sales to their highest level for ten years (March 2009).” [7]

We shall now discuss some of the monetary policy measures taken in response to the financial crisis. The UK, US and Germany all used the conventional monetary policy tool of interest rates, cutting them to historical lows. The theory behind this policy is that saving becomes less attractive, borrowing becomes cheaper and therefore consumption increases, boosting aggregate demand. Asset prices should also increase and the exchange rate depreciate, increasing economic growth.

Interest rates take around 18 to 24 months to have real effects on the economy; we would therefore expect GDP growth and interbank rates to react slowly to the changes. The interbank rates for the UK, Germany and US have decreased but only recently, suggesting that the lower interest rates are beginning to be passed on to the interbank market, with it likely that more effects are to come. GDP growth in the UK and US remains negative with growth rates of -5.1% and -2.5% respectively, however German GDP growth has been positive at 0.7%. UK house prices have been rising of late; also there has been a steady upward trend in stock market since April 2009 in the US and Germany.

Overall the effect of interest rates cuts in these three countries is unclear, mainly because changes can take up to two years to take effect. The impact may therefore become clearer over time. However, asset prices in all three countries have been increasing, suggesting that the interest rate cuts have been in some way successful.

The Bank of England (BOE), Federal Reserve (Fed) and European Central Bank (ECB) have lowered their interest rates to levels which are effectively their ‘floor' levels in terms of conventional economic policy. Central banks have therefore had to consider unconventional monetary policy measures such as quantitative and credit easing to stimulate their economies.

Quantitative easing in its classic form is the policy of the central bank to purchase government bonds from the private sector, financed through the creation of reserves, thus directly injecting more money into an economy. This has been conducted on a large scale by the BOE, amounting to over £175billion. The aim of quantitative easing has been to increase the amount of money banks have therefore directly improving credit conditions, increasing money supply and stimulating economic activity. It has also been used to reduce longer term interest rates in the economy. The BOE has been buying gilts pushing their prices up and thus reducing gilt yields. This has resulted in lower corporate bonds. Many large companies have therefore been financing themselves through the corporate bond market, at a time where it can be difficult and expensive to borrow money. The US Fed's approach was a little different. To begin with the Fed “printed” money in order to buy up the distressed assets of banks such as mortgage backed securities. However, in March it moved to buying long term government debt. Germany does not have a central bank with the ECB setting policy for the whole of the euro area. The ECB has not used quantitative easing; rather it has provided “enhanced credit support” for banks. It has been prepared to lend money to banks at low interest rates for up to a year and accepting a wide range of collateral from banks.

There is no strong evidence of these unconventional measures boosting broad money supply growth in the UK, US or euro area. However, it is difficult to know what would have happened without these measures. The BOE, for example, has argued that given the large percentage drop in nominal GDP, broad money supply growth in the UK is above what it would be otherwise. In addition bond yields in these countries have stayed very low by historical standards.

Another policy conducted on a large scale by the UK, US and Germany in response the financial crisis has been to implement bank bailouts, these have been essential in preventing the collapse of the global financial system. After guaranteeing the survival of a bank, the aim has been to maintain lending levels to consumers and businesses through issuing loan guarantees, short term loans and emergency capital injections.

In Germany the government issued a €500 billion bailout package going towards providing lending guarantees and purchasing risky assets. To benefit from the fund, banks has to allow the government to implement restrictions on their actions, this made some banks reluctant to take on any government funds. The UK has not only provided emergency liquidity assistance and used methods of insurance to maintain confidence levels; there have also been cases of full bank nationalisation in an attempt to safeguard business and consumer deposits. In the US, congress had budgeted $700 billion for the ‘troubled asset relief programme', costs are now expected to be $200 billion lower. Banks have been using less capital than calculated as necessary, showing the path to recovery. The Bank of America received a US$20 billion injection and US$118 billion of guarantees against bad assets. Like in Germany, many large banks were unwilling to take on the additional funding. An example of a failure to stop a company going bankrupt is following an emergency loan made to Bear Stearns who were later bought by JP Morgan who have since acquired Lehman Brothers too.

It is clear that bank bailouts have been quite successful through the fact that many large banks have not collapsed, as was seen in the 1930s depression, when numerous banks didn't hold enough liquid assets to pay required cash withdrawals. However there have been cases where bankruptcy has not been prevented and in countries such as Germany there is still pressure to provide further bank rescue provision as banks continue to hold large quantities of toxic assets. The success of the UK's bank bailouts will also be dependent on whether the government is found guilty of financial protectionism in the rescue of RBS and Lloyds, this could result in the UK facing trade sanctions or further restructuring of the banking system.

We have discussed the various fiscal and monetary measures taken by various countries and their effects. If you look at the graph you can see that all the countries we have discussed are seeing an improvement in their annualised GDP growth rate in the third quarter of 2009, which is one indicator that the various stimulus packages have been successful.

However, it is not possible to analyse exactly how effective monetary policy has been in stimulating economies because it can take up to 2 years for the extra liquidity to be transformed into credit. Furthermore, these results are not completely consistent across the world. A recent development in Dubai, where a large government corporation was unable to meet its interest repayments, has caused £14 billion to be wiped off the value of British banks. As a final thought, a lot of the growth and trade recovery is largely attributable to fiscal stimulus packages. However, as Governments begin to pull back spending will the private sector pick up the slack, or will we experience the widely predicted 'double-dip' recession?



























IMF Staff Position Note: Unconventional Choices for Unconventional Times: Credit and Quantitative Easing in Advanced Economies, Vladimir Klyuev, Phil de Imus, and Krishna Srinivasan, 4th November 2009.


Speech by David Miles, Member of Bank of England MPC, Money, Banks and Quantitative Easing. (http://www.bankofengland.co.uk/publications/speeches/2009/speech404.pdf)

Bank Of England November 2009 Inflation Report. (http://www.bankofengland.co.uk/publications/inflationreport/ir09nov.pdf)

Remarks by B. Bernanke, Stamp Lecture at LSE, The Crisis and Policy Response, January 13th 2009. (http://www2.lse.ac.uk/PublicEvents/pdf/20090113_Bernanke.pdf)

[1] http://www.ajc.com/ajccars/content/business/stories/2008/08/22/rebates.html

[2] Study by Christian Broda of the University of Chicago and Jonathan Parker of Northwestern University

[3] http://www.1stcontact-accounting.com/news/post/VAT-Rate-Cut-An-Evaluation-Of-Its-Impact.aspx

[4] http://news.bbc.co.uk/1/hi/business/8370035.stm

[5] http://www.guardian.co.uk/business/2009/nov/05/uk-car-sales-30-percent-up-october

[6] http://www.smmt.co.uk/home.cfm

[7] http://news.bbc.co.uk/1/hi/7989583.stm