Fuility of monetary policy and Humpty Dumpty back on the wall


By Usvatte-aratchi

Discussions on the nature of economic recovery consequent upon the use of monetary policy in the present context is misguided. Monetary policy commonly implemented by central banks work well when the problem in the economy is demand management. Fiscal policy, designed and implemented by ministries of finance, is more directly powerful at the same job. The breakdown in economies in 2020 is the result of a break down in supply in an interconnected world. If supply breaks down production is interrupted, employment is lost, incomes are lost and, of course, there is a loss of demand. To imagine that transferring funds to those that lost employment will engender demand is a fallacious conclusion, arising from one’s learning that economies break down cause effective demand breaks down. Money transfers to people, even to those in high income groups, will not generate demand. And for several reasons.

Economies broke down when the SARS-COV 2 virus spread rapidly from Wuhan in China. Within roughly three months Hubei Province had been cleared of the virus. There have been sizeable eruptions in many other parts of China after that but public health programmes in that country has been quick so far to contain the spread. In China, when workers went back to their factories, they could not produce because by that time the virus was causing havoc elsewhere in the supply chain and the flow of parts and material had frozen. Samsung in Korea could not produce high value telephones because they could not get parts usually supplied from factories in China. Consequently, production fell everywhere as did employment, incomes and effective demand. Money transfers to people as unemployment insurance or other means cannot restore production, which is that which creates employment and incomes and effective demand. When statistics come out eventually, you will find that the velocity of circulation fell markedly during the months that began in February 2020. To pick on that last link in the chain as if it were the primary cause is to be wholly misguided.

I might receive Rs.5,000 from government but where is the bread that I can buy with that money if workers cannot travel to and assemble in bakeries out of fear of being infected with the virus? Transport to the workplaces is plagued by the same risks. Here I have an advertisement offering a 50 percent discount on air travel to many desirable destinations, which I might have picked up eagerly last year. However, for the next 12 months, at the shortest, almost nothing can persuade me to get into one of those steel and plastic tubes. Ryanair, the largest low-cost carrier airline in Europe lost 99 percent of its passengers in the 2nd quarter 2020 compared to 2nd quarter 2019. Similarly, there are offers from highly desirable seaside resorts at giveaway prices.

I would not risk infection with SARS and take those offers even if with a bonus. The world economy has gone awry not because demand has collapsed but because production has been severely disrupted. In an interconnected world that spread has had more severely adverse consequences than the spread of SARS COV- 2 itself. Even if the number infected with SARS COV-2 were to double the present number of 16 million, no more than 43 per 10,000 would be infected. From among those infected, the number that died so far is 45 per 1,000. In the world population of 7.5 billion, that is about 0.09 per 1,000. Compared to the epidemic ‘Spanish Flu’ 1919-22, this is quite small. Even if we go further back in history, the Black Death in mid-14th century is reported to have taken a third of the population of Europe at that time. The loss of life this time is comparatively quite small.

However, the disruption to economic life was amplified severalfold. We yet do not know how many died from starvation and other deprivations, consequent upon the destruction of livelihoods and because health care systems shut out those patients who were not SARS-COVE 2 infected. Some 5 million students do not go to school, to meet their friends and teachers, to work in libraries, laboratories and studios, to take music lessons and to romp around in playgrounds. Millions of workers do not go to workplaces cutting down production, missing their comrades and losing incomes.

Working from home and learning online are not perfect substitutes. Whole industries have been severely affected, perhaps for good. Transport, leisure industries, entertainment, all kinds of personal services, those depending on the supply of material and parts from other parts of the world, in fact entire economies have been severely hit. Most governments have taken long strides to sustain ‘incomes’ by transferring money to those lost incomes. (These are not incomes because income arises from production and there is no production to match these payments.) Hardships arising from the need to sustain regular periodic payments have been lightened with cancelling, subsidising and or postponing those payments. But suspension of the flow of regular payments suspends flows of incomes to persons who would otherwise have received them. Governments have also gone far to help hold together enterprises large and small to prevent the long term loss of established businesses. The whole ideology regarding the place of government in the economy has been deeply questioned, more widely than earlier.

In the rich economies in the West as well as in Japan money is available almost free. The asset portfolios of central banks have begun to bulge and interest rates are almost zero. Governments can borrow almost without limit because money is available often at 0.25 percent per year on 10 year bonds. The cost of a large public debt is no longer a bar to governments spending money that they do not own. Even if your economy grows at 0.5 per year, the economy can service the larger debt. One practical effect is that central banks can do little to revive economies. There was a commentary two weeks ago that the mighty Fed could do little to revive the US economy. The decision of the European Union to lend about 500 billion euro to some members of the Union came easy when interest rates fell close to zero. When interest rates are close to zero central banks must find an alternative instrument to regulate the economy in the short run. Money no longer has a price.

Neither time preference nor liquidity preference can be a satisfactory explanation any more of the phenomenon of interest in the economy. The Roman Catholic church in the middle ages explained the interest rate as usury, time being a gift of God, it was sinful for a gentile to lend money at a price. Money lending became a preoccupation of Jews, who eventually became shrewd and successful bankers. A group of economists in early 20th century, explained interest as what was paid to people who saved and to reward them for preferring the future to the present- time preference. Keynes and his colleagues found that interest was what was paid to holders of liquid assets (money) to exchange them for less liquid assets- liquidity preference.

Another took capital as an accumulation of savings invested and that capital raised productivity. Interest was the part of that rise in productivity payable to savers- marginal productivity. Hence the use of some interest rate to discount future series of incomes to arrive at net present value. The lower the rate of interest the lower the rate of discount and closer is the sum of flows of incomes over time to discounted present value. Then long term investments become as profitable as short term investments. Economists have a first-rate problem of understanding why interest.

For policymakers, the question is what can revive economies with least losses. It is evident that monetary policy cannot help. The solution is in reducing the rate of reproduction of infections as close to zero as possible. There is little point in giving money to Humpty Dumpty, broken down on the ground. Humpty Dumpty must be put back on the wall to resume productive activity. Then employment, income and demand will rise. And economies revive.

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