In the Wall Street Journal article from February 21, 2020 “The Central Bank Advised to Use Tool Kits Aggressively during Trouble,” it is suggested that a group of top Wall Street economists recommend that central banks consider a more aggressive monetary stance to counter future economic slumps.
Because of the very low level of interest rates in countries such as the US, the central banks are left with almost no ammunition to revive the overall demand should the economic crisis erupt, so it is held.
Thus, during the 2008 economic crisis the federal funds rate target was lowered from 5.25 percent in 2007 to 0.25 percent by December 2008—a decline of 500 basis points. Over the same period the yield on the ten-year US T-Bond fell from 4.81 to 2.21 percent—a decline of 260 basis points.
It is argued by these experts that this time around, given the low level of interest rates, the magnitude of any further lowering of interest rates cannot be the same and hence is unlikely to generate adequate stimulus to keep the overall demand in the economy strong. The federal funds rate target currently stands at 1.25 percent while the yield on the ten-year US T-Bond has now fallen below 1 percent.
It is advised by these top experts that central banks should plan to rely on new monetary tools if the new economic crisis erupts. Among these tools, the key is a commitment to keep rates low into the future, known as forward guidance, as well as a large-scale buying of bonds to ease borrowing costs by pushing plenty of money into the markets.
Although admitting that there is not enough historical data to evaluate the effectiveness of these new monetary tools’ ability to revive the overall demand during an economic crisis, nevertheless experts are of the view that a more aggressive monetary stance is likely to be effective in countering a possible future economic recession.
Economic Growth and the Pool of Real Savings
In order to capture the essence of what economic growth is all about we need to understand that all various tools and machinery that people create are only for one purpose and that is to be able to produce final consumer goods that are required to maintain and promote people’s lives and well-being. For a given consumption of final consumer goods, the greater the production of these goods, the larger the pool of real savings is going to be.
The quantity and the quality of various tools and machinery (i.e., the available infrastructure) place a limit on the quantity and the quality of the production of consumer goods.
Through an increase in the quantity of tools and through the introduction of better tools and machinery a greater output can be secured. The increase in the quantity of tools and their enhancement requires real savings to support the various individuals that are engaged in the production of new tools and machinery.
This means that through an increase in real savings a better infrastructure can be built, laying a foundation for higher economic growth.
According to Mises in Human Action,
The sine qua non of any lengthening of the process of production adopted is saving, i.e., an excess of current production over current consumption. Saving is the first step on the way toward improvement of material well-being and toward every further progress on this way.
Higher economic growth means a larger quantity of consumer goods, which in turn permits more saving and also more consumption. With more savings an even more advanced infrastructure can be created, which in turn is the foundation of a further strengthening of economic growth.
Can a More Aggressive Monetary Stance by the Central Bank Promote Economic Growth?
The suggestion by top Wall Street economists that the central bank should adopt a more aggressive monetary stance in order to protect the economy is missing the point. The view that the lowering of interest rates and the expansion in money supply sets the platform for economic growth is erroneous.
Interest rates are just an indicator, as it were, of individuals’ preferences of future versus present consumption. As an indicator, they have nothing to do with economic growth. They do not cause more or less investment but actually mirror whether for a given pool of real wealth individuals are investing more or less. Any policy that tampers with interest rates distorts the signals that individuals are sending to businesses, causing the misallocation of real savings and economic impoverishment.
Likewise, the money supply, being the medium of exchange, can only assist in exchanging the goods of one producer for the goods of another producer. The service that money as a medium of exchange provides has nothing to do with the production of final consumer goods. This means that it has nothing to do with real savings, either.
As long as the growth rate of the pool of real savings stays positive, it can continue to sustain productive and nonproductive activities.
Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more consumer goods than it releases. (The consumption of final consumer goods exceeds the production of these goods.)
This excessive consumption relative to the production of consumer goods leads to a decline in the pool of real savings. This in turn weakens the support for individuals employed in the various stages of the production structure, resulting in the economy plunging into a slump.
Once the economy falls into a recession as a result of the weakening of the pool of real savings, any government or central bank attempts to revive the economy must fail. Not only will these attempts fail to revive the economy, they will deplete the pool of real savings further, prolonging the economic slump.
The shrinking pool of real savings exposes the erroneous nature of the commonly accepted view that loose monetary and fiscal policies can grow an economy.
The ineffectiveness of loose monetary and fiscal policies to generate the illusion that the central authorities can grow an economy has nothing to do with a lack of effective tools. Policy ineffectiveness is always a reality whenever the central authorities are attempting to “grow an economy.” The only reason why these policies appear to “work” is that the pool of real savings is still expanding.
Making various monetary policies more aggressive in order to boost economic growth is going to generate the opposite results. It is because of the aggressive monetary policies of the central banks that we are in a situation where many experts are wondering why economic activity is not responding as in the past.
