Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 332

Policymakers fear cutting stimulus can lead to recession

At a ‘Fed Listens’ event held where the US central bank’s policy-setting board meets, Federal Reserve Chair Jerome Powell in October 2019 described how the room with “26-foot ceilings, a monumental marble fireplace and a 1,000-pound brass and glass chandelier” had “seen a lot of history since Franklin Roosevelt dedicated this building in 1937”.

That’s probably the most innocuous economic event linking 1937 and the 32nd President. The pairing is more renowned for the ‘depression within a depression’ Roosevelt triggered in his second term when he tightened monetary and fiscal policies after US production surpassed pre-Depression levels.

The controversial and damaging action

Under Roosevelt’s direction, the Fed boosted bank reserve requirements by 50% and the Treasury withheld gold inflows from the monetary base, to guard against inflation. Government spending was cut in a quest to eliminate the federal deficit within two years. The result was the third-worst recession of the 20th century. Real GDP dived 10% and industrial production plunged 32% while the jobless rate jumped to 20% as four million people lost their jobs.

Roosevelt’s premature tightening still haunts US policymakers. Avoiding 1937-style missteps was pertinent in 2016 when the economy was healthy enough for the Fed to tighten monetary policy and for the administration of Barack Obama to reduce budget deficits towards 2% of output from a post-crisis peak of 10% of GDP in 2009.

That the US expansion that began in 2009 has entered a record 11th year shows officials have avoided a 1937 rehash. To help ensure no repeat, the Fed this year resumed loosening monetary policy, while Washington’s budget deficit is widening. President Donald Trump’s tax cuts of 2017 have stretched the shortfall beyond 4% of output.

Stimulus comes with risks

Prolonging an upturn with stimulus is an achievement but it comes with risks. Three leap out.

First is that stimulus can delay adjustments an economy might need to thrive over the long term. Today’s US recovery is sluggish and it is at risk if imbalances metastasise. These distortions include record asset prices and government, household and business debt at worrying levels.

Second, the Fed is unable to respond in a meaningful, conventional way to threats. The central bank has cut the cash rate to between 1.5% and 1.75% and its balance sheet is still distended from three bursts of asset buying (or quantitative easing).

Third, policymakers might need to double down on fiscal solutions to extend the expansion. Washington’s projected deficits, on top of almost continual shortfalls since 1970, are forecast to boost its debt to 95% of GDP by 2029, the highest ratio since just after World War II. At some point, the public and investors could lose confidence in Washington’s budgeting abilities.

US policymakers should ask themselves whether extending the expansion might lead to an uglier downturn than what they might have evaded so far.

To be sure, any slump comes with social costs best avoided; policymakers had little choice politically but to stimulate the economy when they could. The US’s imbalances aren’t as large as those of the Eurozone and Japan, where radical stimulus has largely failed to stir robust growth. 

Stimulant side effects

Herbert Hoover was President when the Great Depression struck in 1929. In his memoirs, Roosevelt’s predecessor told of the advice of his Treasury Secretary, Andrew Mellon.

“Liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate. It will purge the rottenness out of the system.”

The quote summed up the tightening of fiscal and monetary policies that officials followed in the 1930s, the same type of voluntary deflation known as austerity that Europe pursued during the eurozone debt crisis.

Repeated spectacles where austerity misfired by hurting the economy gave credence to the remedies of John Maynard Keynes. The UK economist argued that easing monetary and fiscal policies in tough times and doing the reverse in good times prolongs growth and softens recessions. Such policy activism explains why five of the six longest US expansions of the 34 upturns recorded from the 1850s have occurred since the 1960s.

While advocating macro management, Keynes was aware of its limits, especially with monetary policy. Keynes warned of the ‘liquidity trap’, a concept that describes situations when uncertainty is so great, low interest rates would fail to generate enough demand to ensure full employment.

One question is whether emergency steps could be ineffective or even prompt perverse behaviour. On the fiscal side, policymakers are assessing whether prolonged activism might only lead to torpor and damaged public finances. Italy’s budget deficit, for instance, averaged 3.4% of output from 1995 to 2018, which boosted government net debt from 101% to 120% of output. Yet the economy struggled most years. 

Central bankers are also questioning whether loose monetary policy could reduce the pressure on politicians to take the steps economies need to thrive over the long term. They are aware that the European Central Bank calmed the eurozone debt by 2014 and saved the Euro. But that allowed politicians to duck devising the fiscal, political and banking unions the currency needs to endure.

Avoiding further asset price inflation

Another side effect policymakers are wary of is that stimulus can inflate asset prices and foster risk-taking. The ‘Greenspan put’ described how Fed chief Alan Greenspan repeatedly cut interest rates to insulate the economy from falling stock prices. These cuts rewarded excessive risk-taking, which is often cited as causing the GFC. Does policy activism make people too dependent on stimulus? Household budgets, for instance, appear unprepared for any meaningful rise in interest rates, however unlikely that might appear.

Prolonging stimulus could feed imbalances that recessions usually correct. The ‘Austrian School’ of economics opposes stimulus because slumps rid economies of ‘malinvestment’. While that’s considered extreme, low rates have led to record household, corporate and government debt in many countries. Imbalances typically get corrected one day.

The complications of stimulus don’t argue against heeding the lessons of 1937. They just mean that when policymakers gather in their splendid rooms to ponder options, they must ask themselves if they risk creating a world of rarer but perhaps harsher downturns.

 

Michael Collins is an Investment Specialist at Magellan Asset Management, a sponsor of Firstlinks. This article is for general information purposes only, not investment advice. For the full version of this article and to view sources, go to: https://www.magellangroup.com.au/insights/.

For more articles and papers from Magellan, please click here.

 


 

Leave a Comment:

     

RELATED ARTICLES

Quantum computing would be a world-changing technological leap

US rate rises would challenge multi-asset diversified portfolios

Are concerns about inflation inflated?

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.