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Policy moves into the great unknown

But at what cost?

Policymakers are dreaming up ever more radical experiments to try and pull economies out of what could be the deepest recession in living memory. But until the world can cure its addiction to debt, financial markets will remain on a knife edge.

In 1890, a New Yorker named Eugene Schieffelin took his love of William Shakespeare and ornithology to the next level by releasing 60 starlings, imported from England, into Central Park. He did the same with another 40 birds the following year.

Schieffelin’s dream was to introduce all the birds mentioned in Shakespeare’s plays to North America. Unfortunately, his plan was too successful for its own good. Scientists estimate US descendants from those two original flocks now number more than 200 million. The rapid spread of a bird that was not native to North America came at the expense of many other birds that compete for nest holes in trees. As well as the damage they have caused to local ecosystems, starlings have had a negative impact on the US economy – destroying agricultural crops, transmitting diseases to humans and other animals, and even causing damage to aircraft.

The story illustrates that even the most well-meaning of actions can have drastic unforeseen consequences. Fast forward to today, and parallels can be drawn with the situation facing policymakers trying to deal with the scale and breadth of the economic fallout from COVID-19. The circumstances dictated they had little option but to respond in dramatic fashion. While the unique nature of the problem means they are unlikely to stop a deep recession, financial market participants hope they will succeed in preventing lasting scars.

However, these responses come with big risks. As with Schieffelin’s starlings, they are highly experimental. There are likely to be multiple unintended and unknowable consequences. Exacerbating these concerns is the fact many countries are already stuck in a high-debt, low interest rate trap with no obvious means of escape. Even in the most optimistic scenario, where economies are able to snap back quickly, policymakers are likely to be dealing with the fallout of this crisis for years to come. This could have profound implications for investment markets.

Central banks act true to form

As the economic impact of COVID-19 became clearer, central banks were quick to flood financial markets with liquidity, slash interest rates where they had room to do so and purchase financial assets in unprecedented quantities. The immediate aim was to restore calm to jittery financial markets. Against that yardstick the measures can be judged a success.

A large part of the explanation for the rally in risk assets since March is that yields on government bonds have been pinned to the floor. For example, the yield on 30-year US Treasuries sank to a record low of 0.94 per cent on March 9 after the Federal Reserve pledged to buy unlimited amounts of government debt, while yields on 30-year debt offering inflation protection went negative for the first time. Other countries’ bond markets reacted in similar fashion with 30-year UK government bond yields falling to a record low of 0.50 per cent, and the yield on 30-year German bunds returning to negative territory.1

Figure 1: US 30-year Treasury yields sink to record low
US 30-year Treasury yields sink to record low
Source: Refinitiv Datastream

Central bankers are trying to limit the depth and duration of the current global recession by preventing credit from contracting too sharply. But the evidence of the past decade suggests the price of their actions could be ever more tepid growth further ahead. As US Federal Reserve chairman Jerome Powell recently conceded: “The path ahead is both highly uncertain and subject to significant downside risks,” and the US risked an “extended period of low productivity growth and stagnant incomes”.2

The debt disease

Part of the problem is that most of the developed world went on a credit binge in the run up to the financial crisis which it has never had to wean itself off due to central banks’ actions. While banks have managed to get leverage down, that has been replaced by record debt issued by non-financial corporations, private equity groups and others. And although household debt has fallen in the US and other countries, that debt has merely been transferred to governments.

According to the Institute of International Finance, global debt totalled $255 trillion at the end of 2019. That was the equivalent of 322 per cent of GDP, 40 percentage points higher than in 2008 at the onset of the global financial crisis.3

There is a limit to how much credit an economy can absorb

Although rising levels of credit can lift spending and economic activity temporarily, there is a limit to how much credit an economy can absorb. Even in a world of zero interest rates, ever higher principal repayments will eventually begin to overwhelm any benefit of low debt servicing costs and start eating into spending. There is no way of knowing for sure, but the danger is most developed countries are now at, or at least close to, that point, and maybe even well beyond it.

In the US, credit creation, as measured by M2 money supply, rose broadly in line with economic output between 1960 and 1982. But since then, the relaxation of banking regulations and availability of ever cheaper money has led to the rate of credit creation far exceeding economic growth. The gap has been especially pronounced over the past two decades. As Figure 2 shows, whereas M2 has risen 210 per cent since the start of the century, nominal economic output has risen by just over half that. Moreover, the divergence has been greatest over the past decade.

Figure 2: US credit expansion outpaces economy
US credit expansion outpaces economy
Source: Federal Reserve Bank of St. Louis

One potential route to lowering debt burdens would be strong economic growth. Unfortunately, growth across the developed world has been on a sharp downward trajectory for more than half a century. As Figure 3 shows, trend growth in real GDP in the G7 has plunged from around five per cent in the early 1960s to little more than one per cent today.

Figure 3: GDP in long-run decline across G7
GDP in long-run decline across G7
Source: Federal Reserve Bank of St. Louis

Adverse side effects

A number of factors could be at play here. Ageing populations, for example, have meant spending on healthcare, social care and pensions has consumed an ever-rising share of scarce resources.

Nevertheless, and even while recognising ultra-low interest rates have suppressed the cost of servicing debt, there are reasons to believe central banks’ actions may be doing more harm than good.

Across developed nations, productivity growth has been declining for at least three decades

Take productivity, the ultimate determinant of an economy’s potential growth rate. Across developed nations, productivity growth has been declining for at least three decades. For example, since 1990, US labour productivity grew just 78 per cent. While there are many reasons for this, it appears central banks’ policies could be exacerbating the problem. Far from incentivising investment, they seem to be discouraging it.4

Public and private companies have taken advantage of low interest rates to issue record amounts of debt over the past decade. But since an immediate financial gain today is worth more than a potential future one through investment, rather than being used to fund new capital projects, companies have often found it more profitable to focus instead on financial engineering. Listed companies have looked to boost shareholder returns via stock repurchases and dividends, while private equity activity has surged.

“To get back to some sort of economic normality we need to get away from the zero lower bound and push up the rate of return on capital,” says Patrick Minford, professor of applied economics at Cardiff Business School and a former advisor to the UK government.

Worryingly, when one looks ahead, companies have been reining in capital expenditure to preserve cash. It is not obvious there will be a strong pick-up when economic growth returns. While some have compared the battle against COVID-19 to a war, as former International Monetary Fund chief economist Olivier Blanchard noted: “Uncertainty is likely to lead to low investment; unlike a regular war, there is no capital to rebuild.”5

The paradox of age and wealth

Low interest rates are also designed to boost economic activity by encouraging greater household consumption through: the wealth effect via higher asset prices; making saving less attractive; and increasing disposable income by lowering the cost of servicing mortgages and other forms of debt. Once again, however, there are reasons to believe monetary policy is having unintended consequences that are at the very least blunting its effectiveness.

Take wealth effects and savings. Low rates have undoubtedly provided rocket fuel to financial assets, as reflected by the ratio of household net worth to household income surging to a record high in most countries over the past decade. Yet less of this additional wealth has been spent than might have been expected because of soaring inequality. Assets are disproportionately owned by the wealthiest, who have a much lower marginal propensity to consume.

Figure 4: US net worth vs. disposable income
US net worth vs. disposable income
Source: Federal Reserve Bank of St. Louis

This helps explain why there is little evidence of falling savings rates.

According to OECD data, while household saving has declined in the UK over the past decade, in Germany, which has one of the oldest populations of any European country, the opposite has happened. As Figure 5 shows, the country’s savings rate, after initially falling, has been on the rise.

Figure 5: Germany personal savings ratio
Germany personal savings ratio
Source: OECD. Shows household savings as per cent of disposable income

An even more extreme trend can be seen in the US, where the personal savings rate, having hit a post-war low of 2.2 per cent in July 2005, has since climbed steadily to around eight per cent.6

The fact populations have been ageing across the developed world offers a further clue why low interest rates have failed to discourage saving. By depressing prospective investment returns, they could be encouraging people to plough more of their income into their pensions, especially as they approach retirement.

As people age, they lift consumption by far less in response to monetary policy shocks

As for the idea falling debt servicing costs have put more money into consumers’ hands, while that may be true for younger households, lower rates have simultaneously taken money away from savers. That is why in September last year Japan’s central bank governor Haruhiko Kuroda warned excessively low yields could damage consumer sentiment as returns on pensions and other long-term investments dropped.7

Research by Princeton economist Arlene Wong shows that as people age, they lift consumption by far less in response to monetary policy shocks. Since they have smaller outstanding mortgage balances, they have less incentive to refinance following an interest rate cut. Indeed, for those reliant on pension income she finds evidence lower rates lead to lower spending.8

Inflation and the law of diminishing returns

In the absence of strong economic growth, a second route to lowering debt and avoiding a painful round of defaults and debt restructurings would be higher inflation. However, recent evidence does not support this idea. When central banks first deployed unconventional monetary policy in the wake of the financial crisis, there were widespread warnings of much higher inflation.

China, Germany and Japan have exported deflation to the rest of the world

Yet, while asset price inflation may have ensued, this has not been mirrored by rising consumer prices. This is partly because China, Germany and Japan have exported deflation to the rest of the world. All three are large manufacturing exporters, have a massive surplus of saving over investment and huge trade surpluses. Now, with unemployment soaring across the world, and precautionary saving likely to rise sharply, the threat of inflation arguably looks even more remote, at least for now.

Central banks are naturally keen to dispel the idea they have run out of ammunition and are powerless to prevent what looks increasingly likely to be the deepest recession since the Great Depression. However, since it typically takes up to 500 basis points of interest rate cuts to fight recessions, growing doubts over the effectiveness of monetary policy are understandable.

As former Federal Reserve Chairman Ben Bernanke wrote in 2016, since the benefit of low rates may erode over time and the costs are likely to increase, at some point monetary policy faces “diminishing returns”.9 For example, as interest rates approach zero, there is progressively less scope for households to fix mortgages at lower rates.

The return of big government?

As a result, pressure on governments in advanced countries to get deficits under control has suddenly evaporated and the ideas of John Maynard Keynes, the original advocate of fiscal activism during the Great Depression, have been revived.

Washington has already passed $3 trillion in fiscal stimulus measures since the crisis began, equivalent to 15 per cent of GDP, and Democrats in Congress are pushing for that to be doubled.10 Governments elsewhere are promising vast sums as they attempt to play the role of consumer of last resort amid spiralling unemployment and precautionary savings.

Additional fiscal stimulus may be “worth it” if it helps prevent otherwise sound companies going bankrupt and keeps workers in jobs

Many economists would see big deficits as a price worth paying to combat the crisis. Few would take issue with Powell when he recently said additional fiscal stimulus may be “worth it” if it helps prevent otherwise sound companies going bankrupt and keeps workers in jobs as “deeper and longer recessions” tended to leave “lasting damage to the productive capacity of the economy”.11

Where there is less agreement is on the longer-term implications of ballooning government deficits for economic growth. While fiscal stimulus can help pull an economy out of a depression, the quid pro quo will almost inevitably be weaker growth further ahead.

Alice in Wonderland economics

Charles Goodhart, former chief economist at the Bank of England, says much of the lost demand from recent weeks, especially within the services sector, is permanently lost. “The daily commute to work, or the horrifically executed haircuts at home, will not be demanded twice over whenever normal life resumes.”12

Minford, meanwhile, says while he is hopeful the recession can end as quickly as it began, “to believe governments can simply pay people to stay at home, borrow money and that there won’t be an economic cost to that is to believe in Alice in Wonderland economics”.

In 2010, US economists Carmen Reinhart and Kenneth Rogoff published a paper Growth in a Time of Debt in which they presented evidence suggesting high levels of public debt had negative consequences for economic growth. The widely cited paper sparked a lively debate among economists, not least because it was seized upon by politicians to justify fiscal austerity.

Following widespread criticism of their methodology and findings, the economists presented new data in 2012 and repeated their claim that where gross public debt exceeds 90 percent of nominal GDP on a sustained basis it has a negative impact on growth, even when markets seem willing to absorb it at low interest rates.13

According to the OECD, average general government debt-to-GDP ratios among G7 countries had by 2018 risen to 134 per cent, having a decade earlier been under 100 per cent.14 Moreover, those numbers do not take into account unfunded liabilities such as pension and healthcare costs. In many cases, these are substantial. This helps explain why UK Chancellor Rishi Sunak is reportedly considering scrapping a guarantee that the basic state pension will rise by a minimum of either 2.5 percent, the rate of inflation or average earnings.15

Economists cannot agree on what higher government deficits mean for economic growth

Part of the reason economists cannot agree on what higher government deficits mean for economic growth is they have such different takes on how they should be funded. The orthodox view is deficits eventually need to be reduced to more manageable levels by either growing tax receipts or cutting spending. Failure to do so leads to interest rates climbing and private sector investment being ‘crowded out’.

This explains why OECD secretary general Angel Gurría has warned rising debt levels will “come back to haunt us”,16 and the UK’s Institute for Fiscal Studies said in March “the tax and spend trade-offs facing policymakers will be made starker for years, and more likely for decades, as they strive to bring debt back down”.17 Sunak is also reportedly contemplating raising taxes to pay for increased spending.18

Minford believes it would be an error to lift taxes too soon. “With the benefit of hindsight, the austerity policies many countries adopted after the financial crisis were a mistake. As we come out of this recession, we need expansionary policy to continue to keep the economy growing,” he says.

Monetary financing

The idea bigger deficits will ultimately lead to higher taxes or lower spending is deeply ingrained in traditional teaching of economic and financial theory. However, a growing band of economists argue central banks should simply print the money. Followers of modern monetary theory go as far as to propose permanent ‘monetary financing’, arguing governments need never issue debt to finance spending.

Adair Turner, chairman of the UK’s Financial Services Authority during the financial crisis, is among those advocating monetary financing, albeit on a “one-off and disciplined” basis. He believes had authorities chosen this route in 2009, the likely result would have been stronger economic growth, higher inflation, a quicker return to ‘normal’ levels of interest rates, and less public and private sector debt.

The beauty of monetary finance is it does not create a debt contract into the future

“The beauty of monetary finance is it does not create a debt contract into the future. By refusing to consider that option we were left with very low interest rates as our only tool. What they do is make it easier to create private credit, which is an alternative way of stimulating the economy, but one which creates future vulnerability,” he explains.

The suggestion they should break such a long-held and sacred taboo by financing government deficits directly is understandably abhorrent to central banks. In April, Governor Andrew Bailey denied the Bank of England was using monetary financing, sometimes known as ‘helicopter money’, which he said would damage its credibility to control inflation. He noted permanent expansions of central banks’ balance sheets with the aim of funding governments has been linked in other countries to runaway inflation.19

Turner believes that is no reason to rule out the option. “If you say we shouldn’t be doing monetary finance because it will lead to inflation, then you shouldn’t be cutting interest rates or doing QE. It all boils down to how much you do.”

He is not alone. Mervyn King, one of Bailey’s predecessors, recently said the question was not whether the central bank should print money to buy government bonds, but rather “how much”.20 Bernanke too has said it would be premature to rule it out.21

A game of illusion

For now, it seems likely that, while central banks will continue buying government debt in record quantities, they will maintain these purchases are temporary and reversible.

As Lord Turner puts it: “We’ve been terrified of increasing high-powered money, so we’ll end up doing it while continuing to deny we’re doing it. This is what Japan has done because central banking is a bit like the Wizard of Oz, a game of illusion.”

Companies have benefitted from massive state support

Japan’s public debt to GDP ratio has in recent years soared to 225 per cent, with 40 per cent of the debt owned by the Bank of Japan.22 Few economists or financial market participants expect much, if any, of that debt to ever be sold. The danger is the only people who do believe it are consumers who then restrain consumption in anticipation of higher taxes, negating much of monetary financing’s potential stimulatory benefit.

While much of the fiscal stimulus announced recently is intended to shield households from the worst effects of the COVID-19 crisis, companies have also benefitted from massive state support.

Washington for instance in April promised $25 billion for the crippled airline industry. The previous month, the British government effectively nationalised the country’s rail operators on a temporary basis to prevent them entering insolvency. France has said it will use all means to support big companies, including nationalisation if necessary.

State intervention

With central banks simultaneously mopping up record amounts of corporate debt to suppress borrowing costs, some reckon the inevitable consequence will be more state intervention in the coming years. Billionaire US investor Leon Cooperman says the crisis will change capitalism forever.

When the government is called upon to protect you on the downside, they have every right to regulate you on the upside

“When the government is called upon to protect you on the downside, they have every right to regulate you on the upside. So capitalism is changed,” the chairman and CEO of Omega Advisors told CNBC.23

In March, US Democratic Senator Elizabeth Warren demanded any company being bailed out be permanently barred from share buybacks, be prohibited from paying out dividends or executive bonuses for three years, and offer a minimum of one seat on their board to a workforce representative.24

While the proposals went too far for Republican lawmakers, President Donald Trump said in March: “I want money to be used for workers and keeping businesses open, not buybacks.”25

As many bankers learned in 2008, government bailouts typically come with strings attached. In exchange for their support, it is inevitable politicians will demand restrictions on some companies that have been bailed out to make the rescues more politically palatable. Whether that leads to more widespread intervention in corporate affairs remains to be seen.

Minford, a prominent supporter of the free market policies of former UK Prime Minister Margaret Thatcher, believes governments should resist the temptation to intervene too heavily. “I think the state’s role is going to be seen as increasingly important given the nature of the current healthcare crisis. But I don’t think this necessarily should equate to a bigger or more interventionist state,” he says.

Economic nationalism

The crisis looks set to cause lasting changes for companies in other ways. For example, the over-reliance of global supply chains on China, be it in healthcare equipment, pharmaceuticals, or automobiles, has become clear.

Already it looks as if economic nationalism is speeding up. For instance, in April Japan set aside 243.5 billion yen to help pay for manufacturers to shift production out of China, its biggest trading partner.26

A number of European politicians have also been using the pandemic to justify a softening of their commitment to competition and the free market. “You should use all options to protect critical European companies from foreign takeovers or influence that could undermine our security and public order,” said Ursula von der Leyen, president of the European Commission.27

Infrastructure spending seems likely to rise as governments look to revive their economies

The crisis could trigger increased state involvement in economies in another important way. Infrastructure spending seems likely to rise as governments look to revive their economies. As Minford says: “In the current situation that would be an obvious way to boost economic activity. Moreover, so long as the money is spent sensibly it ought to be good for productivity.” Lord Turner agrees that it would make sense for governments to try to lift productivity by rolling out new fibre-optic networks and speeding up progress towards a zero-carbon economy.

Unfortunately, projects such as these take time to get off the ground. In the meantime, governments may have to content themselves with accelerating smaller-scale projects such as refurbishing properties, schools and hospitals that were already slated to get improvements “to help get the construction sector going as much as possible”, says Lord Turner.

Investment risks increase

As monetary policy becomes ever more experimental and government deficits balloon, it is increasingly difficult to forecast asset returns. Long-term investors like pension funds and insurance companies are being forced to take more risk to secure ever lower levels of income.

It is possible developed economies will rebound reasonably quickly, especially if a vaccine for COVID-19 can be found, and thereafter respectable levels of growth will return with moderately higher inflation. In that environment interest rates could stay extremely low, encouraging further demand for carry trades and underpinning the price of riskier assets everywhere.

Financial assets do not need strong economic growth to deliver stellar returns

As recent experience proves, financial assets do not need strong economic growth to deliver stellar returns so long as they can rely on a supportive monetary policy environment. But the uncomfortable truth for investors is that policymakers are fast running out of road.

“With 30-year Treasuries yielding little more than one per cent, investors need to lower their return expectations across the board. The kind of returns we’ve seen over the past ten years are not going to be repeated this decade, no matter what policy response central banks magic up,” says Peter Fitzgerald, multi-asset and macro chief investment officer at Aviva Investors.

While central banks could theoretically buy more corporate bonds and even equities, this creates moral hazard. The decision by many corporations to take on so much debt in recent years has reduced their capacity to weather the storm.

More upheaval ahead?

Moreover, it is important to remember the ultimate goal of monetary policy is to support economic activity and not boost asset prices. If such measures widen inequality even further, the risk will be more social upheaval.

Lord David Willetts, a former member of the British government, says it is already clear monetary policy has played a crucial role in fuelling inequality by boosting wealth far faster than incomes. “This surge in wealth relative to income is at the heart of a lot of what’s going wrong. It’s changing the character of society,” says Lord Willetts. He believes governments will inevitably have to tax wealth more heavily.

The monetary policy experiment of recent years is having multiple adverse and unintended consequences for economies

It is clear the monetary policy experiment of recent years, as with the release of the hapless Schieffelin’s starlings, is having multiple adverse and unintended consequences for economies. By promising ever more extreme measures and layering massive amounts of debt on top of an already huge pile, those adverse consequences could multiply.

For now, it seems unlikely central banks will experiment with pure monetary financing as it would represent an even bigger leap into the unknown. But as Lord Turner says: “If our only way to get out of this trap is via setting interest rates so low as to create strong incentives for private credit growth, we seem condemned to repeat the same mistakes of the past.”

Until authorities can find a way to raise interest rates to more normal levels and simultaneously lower debt burdens, financial markets will continue to live on a knife edge. In terms of investing, Fitzgerald says the need for portfolios to be diverse and resilient to a wide range of outcomes, including high levels of both deflation and inflation, has never been greater.


  1. Source: Refinitiv Datastream
  2. Jerome H. Powell, ‘An Economic Update by Fed Chair Jerome H. Powell’, Peterson Institute For International Economics, May 13, 2020
  3. ‘Global Debt Monitor’, Institute of International Finance, May 2020
  4. Source: Federal Reserve Bank of St. Louis
  5. Olivier Blanchard, ‘High inflation is unlikely but not impossible in advanced economies’, Petersen Institute for International Economics, April 24, 2020
  6. ‘Household savings’, OECD, May 2020
  7. Daniel Leussink and Leika Kihara, ‘BOJ’s Kuroda says deepening negative rates is among options: Nikkei’, Reuters, September 6, 2019
  8. Arlene Wong, ‘Refinancing and The Transmission of Monetary Policy to Consumption’, May 2019
  9. Ben Bernanke, ‘What tools does the Fed have left? Part 3: Helicopter Money’, Brookings Institution, April 11, 2016
  10. Sergei Klebnikov, ‘Republicans ‘appalled’ by $3 trillion heroes act as Democrats urge its passing’, Forbes, May 17, 2020
  11. Jerome H. Powell, ‘An Economic Update by Fed Chair Jerome H. Powell’, Peterson Institute For International Economics, May 13, 2020
  12. Charles Goodhart and Manoj Pradhan, ‘Future imperfect after coronavirus’, VoxEU.org, March 27, 2020
  13. Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, ‘Public Debt Overhangs: Advanced-Economy Episodes since 1800’, Journal of Economic Perspectives, Vol. 26, No. 3, Summer 2012
  14. Source: OECD Website
  15. Gordon Rayner and Anna Mikhailova, ‘Exclusive: Treasury blueprint to raise taxes and freeze wages to pay for £300bn coronavirus bill’, Daily Telegraph, May 12, 2020
  16. Martin Arnold, ‘Pandemic stimulus debt will ‘come back to haunt us’, warns OECD’, Financial Times, May 13, 2020
  17. Carl Emmerson and Isabel Stockton, ‘The economic response to coronavirus will substantially increase government borrowing’, Institute for Fiscal Studies, March 26, 2020
  18. Gordon Rayner and Anna Mikhailova, ‘Exclusive: Treasury blueprint to raise taxes and freeze wages to pay for £300bn coronavirus bill’, Daily Telegraph, May 12, 2020
  19. Andrew Bailey, ‘Andrew Bailey: Bank of England is not doing ‘monetary financing’’, Financial Times, April 5, 2020
  20. Chris Giles, ‘Bailey rejects monetary financing as tool in virus crisis’, Financial Times, April 6, 2020
  21. Ben Bernanke, ‘What tools does the Fed have left? Part 3: Helicopter Money’, Brookings Institution, April 11, 2016
  22. Source: Macrobond
  23. Jesse Pound, ‘Leon Cooperman says the coronavirus crisis will change capitalism forever and taxes have to go up’, CNBC, April 23, 2020
  24. Joseph Zeballos-Roig, ‘Elizabeth Warren just laid out 8 conditions that companies should accept for government bailout money during the coronavirus crisis’, Markets Insider, March 18, 2020
  25. Ian Millhiser, ‘The fight over stock buybacks and corporate coronavirus bailouts, briefly explained’, Vox, March 21, 2020
  26. Isabel Reynolds and Emi Urabe, ‘Japan to fund firms to shift production out of China’, Bloomberg, April 9, 2020
  27. Guy Chazan and Jim Brunsden, ‘Coronavirus crisis pushes Europe into nationalist economic turn’, Financial Times, March 26, 2020

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