David Wu | International Trade and Economy Fellow
The global COVID-19 pandemic has spilled over into the economy with many expecting we are in the midst of a global recession of a magnitude that will exceed any experienced in the last 150 years. In response, central banks and governments around the world have lowered interest rates, started programs of quantitative easing and unleashed stimulus packages at an intensity that has pushed the global economy into unfamiliar terrain. What are the implications of these pandemic-induced economic policy developments?
Central banks the world over are reducing interest rates, lending freely to financial institutions and encouraging financial institutions to extend credit in a bid to mitigate the economic wreckage caused by the pandemic.
Given the dire outlook, the Reserve Bank of Australia (RBA) has targeted a historically low interest rate and yield on government bonds of 0.25 per cent. The US Federal Reserve has similarly cut interest rates to near zero and has launched a program of quantitative easing with an open-ended scale. The European Central Bank, for its part, has launched a temporary pandemic emergency purchase program with an asset allowance of up to €750 billion (A$1.3 billion) through to the end of the year or longer.
In many developed economies, low interest rates are part of a long-term trend. The interest rate set by the RBA has steadily declined from 17.5 per cent in 1990 down to 5 per cent in 2000. It then declined further to the present rate in the aftermath of the global financial crisis. And while central banks can influence the interest rate in the short run, it is otherwise largely determined by a multitude of factors, notably economic growth. Even so, the effect of the pandemic has been to squeeze the space available for conventional monetary policy levers and forced central banks to take unconventional approaches, including quantitative easing.
After playing a role in the US, European and Japanese responses to the global financial crisis, quantitative easing has rightfully earnt a place in central banks’ toolkits for the present pandemic.
Like central banks elsewhere, the RBA has embarked on a A$5 billion bond-buying exercise in response to the pandemic. Yet, concerns and unknowns remain around undesirable side effects from its use. At home, this includes concerns around increased risk-taking by investors seeking to maintain rates of return and the excessive accumulation of debt by borrowers in response to lower interest rates. Abroad, this includes destabilising international spillovers into developing countries as investors seek higher rates of return abroad, leading to currency appreciation, as well as a loss of export competitiveness, inflated asset prices and exchange rate instability in developing countries.
The unprecedented response to the present crisis will be a further test of the effectiveness of quantitative easing.
Complementing the response of central banks, governments have also launched stimulus packages as another channel through which to protect the economy and to mitigate household and business hardship. The Australian Treasury has led a A$320 billion stimulus plan. Its US counterparts are intending to spend more than US$3 trillion (A$4.6 trillion). Such spending is set to achieve record levels in both countries and elsewhere. Most packages include income subsidies and cash transfers for individuals and wage subsidies and cashflow support for small-to-medium-sized businesses.
There is concern, in particular, for developing economies’ prospects of weathering the growing economic headwinds. Compared to developed economies, developing economies tend to have limited fiscal space to respond to economic shocks due to borrowing constraints and limited sources of government revenue. Large informal economies and economic activity which is concentrated in sectors such as labour-intensive manufacturing and tourism will also pose unique challenges. While foreign aid from institutions such as the International Monetary Fund, World Bank and Asian Development Bank can help to address such issues, more concerted multilateral coordination will be necessary.
For central banks, multilateral coordination can take the form of currency swap lines, policy coordination and the sharing of experiences. It is important that such coordination is inclusive. The presence of key developing economies within the network of swap lines should be expanded and strengthened. Given the role of the US dollar as the world’s currency, the expansion of swap lines by the US Federal Reserve is particularly important.
On the part of government treasuries, multilateral coordination can increase the effectiveness of fiscal stimulusand — particularly through forums such as the G20 — provide policymakers with the political capital necessary to push through ambitious policy actions. For developing economies, coordination with multilateral and regional institutions will be especially important.
Given the subdued and uncertain economic conditions and significant hardship, households and businesses the world over will continue to appeal to their governments for assistance. Until the spread of COVID-19 has been confidently contained — both at home and abroad — governments will be inclined to continue policies that directly support households and businesses. Indeed, they may well find that such policies are difficult to eventually unwind or must be left in place. Post COVID-19, it appears that the role of governments in economies will increase relative to that of markets.
David Wu is the International Trade and Economy Fellow for Young Australians in International Affairs.