The writer is the chief economist of the IMF
Fighting the worst economic downturn in living memory, policymakers around the world have responded forcefully. Discretionary fiscal support of about $12tn has eclipsed previous records. Central banks, by going big with monetary easing, liquidity injections and asset purchases, have prevented financial catastrophe. Now we are in a global liquidity trap. The ascent back from what I have called “the great lockdown” will be long and fiscal policy will need to be the main game in town.
For the first time, in 60 per cent of the global economy — including 97 per cent of advanced economies — central banks have pushed policy interest rates below 1 per cent. In one-fifth of the world, they are negative. With little room for further rate cuts, central banks have deployed unconventional measures.
Despite this effort, persistently low inflation — and in some cases intermittent deflation — has raised the spectre of further monetary easing to achieve negative real rates if another shock strikes. It has led to the inescapable conclusion that the world is in a global liquidity trap, where monetary policy has limited effect. We must agree on appropriate policies to climb out.
The central banks’ measures have been essential to meet the liquidity needs of businesses and households and to preserve jobs. Yet such policies are limited in their ability to stimulate demand. Solvency risks now predominate. Vulnerable but viable firms require support, a problem that is much better addressed by fiscal policy.
Before the pandemic, there was a worrying consensus that low-for-long interest rates had promoted excessive risk-taking that heightened financial stability risks. The striking disconnect of financial markets from real activity in the recovery from the Covid-19 crisis reinforces these notions.
There is also a greater risk of currency wars in a global liquidity trap. When interest rates are near zero, monetary policy works to an important extent by weakening currencies to favour domestic producers. With the pandemic already testing the limits of multilateralism, the world can ill-afford the escalation of tensions that competitive devaluations are likely to generate.
Fiscal policy must play a leading role in the recovery. Governments can productively counter the shortfall in aggregate demand. Credit facilities installed by monetary authorities can only assure the power to lend but not to spend, as US Federal Reserve chair Jay Powell has noted. Fiscal authorities can actively support demand through cash transfers to support consumption and large-scale investment in medical facilities, digital infrastructure and environment protection. These expenditures create jobs, stimulate private investment and lay the foundation for a stronger and greener recovery. Governments should look for high-quality projects, while strengthening public investment management to ensure that projects are competitively selected and resources are not lost to inefficiencies.
Many economies can lock in historically low interest rates now and keep debt servicing costs low. The IMF’s latest projections are for economic growth to increase at a faster rate than debt service costs in many countries — and by an even bigger margin in absolute terms than before the pandemic. This implies that debt service costs could fall. That would provide room in many economies for investment in inclusive, strong and sustainable growth, without compromising debt sustainability or bond market access.
The importance of fiscal stimulus has probably never been greater because the spending multiplier — the pay-off in economic growth from an increase in public investment — is much larger in a prolonged liquidity trap. For the many countries that find themselves at the effective lower bound of interest rates, fiscal stimulus is not just economically sound policy but also the fiscally responsible thing to do.
While all countries will need to deploy fiscal policy, the stimulus size will clearly vary. Those that entered the crisis with elevated debt and weak growth prospects will need to prioritise spending and seek financial support. Those whose debt is unsustainable should restructure as soon as possible to free up resources to fight this crisis. All countries should build medium-term fiscal frameworks to ensure debt remains sustainable, including through structural reforms, revenue-raising measures and cuts to wasteful spending.
This is a once in a lifetime crisis. Policymakers have responded strongly, averting an even deeper recession. Monetary policy has and will remain central to this effort, but with the world in a global liquidity trap it is time for a global synchronised fiscal push to lift up prospects for all.