This is not a dictator making a run for it, but the beginning of a new and unprecedented phase of central bank intervention not just in the money market, but also in the real economy.
Due to the pandemic, national economies are confronted with an unparalleled situation, where a big chunk of economic activity has come to an almost complete stop. Both aggregate demand and supply have been hit hard in just a matter of weeks, which risks to actually bring a significant share of the economy to a halt across many countries no matter their degree of development. Deterring people from leaving their home puts a damper on their willingness and even their ability to consume, while not working has its own adverse effects.
The risk of a general economic collapse is real and it originates in having people suspend their capacity to buy goods and services, as well as to produce and provide them. There is just a small step from here to a full-blown financial crisis. The longer the standstill, the wider the scarcity of people’s savings and companies’ reserves which will make it impossible for them to meet their financial obligations. The nonperforming loan ratio will start to go up and put increased pressure on the banking system with the risk that some banks will go under. Mistrust will come back with a vengeance, a 2009 crisis reloaded.
To avoid this scenario, at least two vital conditions need to be met: the epidemiologic status that requires stay-at-home orders should only last up to 2 – 3 months and consumption needs to be kept alive at all cost.
As I mentioned on other occasions, interest rate cuts will not help with the second condition. It is not with low rates that central banks will entice people into going out and resuming buying. If your job and money are gone, interest rates become irrelevant. Cash injections into the banking system can only make sure it operates properly. Neither will help consumption keep its head above the water. The only way to do that for a period of 3 months is “helicopter money”. Do not expect to see money falling from the sky. It simply means that some central banks will provide cash to individuals through the national budget.
The previous crisis already set a precedent for central banks funding budget deficits. The efficient use of this money is questionable in my view as a good share of that money will not originate in the real economy but in overvalued financial and real-estate assets. However, governments’ plan to directly fund households ushers in a new era where central bank money reaches people’s pockets via government actions.
Yes, I know, some central banks only operate on secondary markets to avoid financing governments directly. That does not mean that they do not indirectly finance governments through banks that sell central banks government bonds to make room for new bond purchases.
We are already seeing countries planning for large scale helicopter drops. The US$2 trillion package signed by president Trump also includes a $1,200 individual payment to most Americans to cover minimum consumption. South Korea also intends to pay $816 million to all families, except for the wealthiest 30 percent.
You may be surprised to learn that the Romanian central bank (NBR), too, is taking small steps in the same direction even though nobody says it explicitly. The NBR announced after its monetary policy Board meeting that it had decided to “buy RON government bonds on the secondary market with the view of strengthening structural liquidity across the banking system to help finance the real economy and the public sector on favorable terms”. This is, I believe, just part of the explanation. The main problem with bank lending to the economy does not lie in a lack of cash, but in risk management. How can you lend companies that have shut down or lost their clients overnight at an acceptable level of risk?
Even before this crisis, the exposure of Romanian banks to government bonds was high so they didn’t have much room for maneuver left. But the prospect of using the NBR purchases on the secondary market to clean up their portfolios will allow them to buy new government bonds on the primary market. The cycle, however, does not end here. Some of the bail-out measures announced by the government include taking over furlough payments. This will close the loop meant to put the money printed by the NBR into the pockets of most Romanians who had been sent home by their employers.
A legitimate question is raised, though: will this unprecedented behavior by central banks lead to a spike in inflation? Despite what many believe, inflation is not related to money supply alone. If that were true, an inflationary response is guaranteed. Inflation actually depends on another extremely important variable: the velocity of money, that is the number of transactions carried out.
For example, if the money supply is constant, but people want to get rid of money by frantically buying goods and services, inflation will increase, although the amount of money on the market remains the same. We are now in the other scenario. Money supply does increase following central bank cash injections, but the speed at which money circulates is falling so sharply that the likelihood of an inflationary spike in the short run is low. Lower velocity of money is clearly linked to collapsing consumption and people’s willingness to put money aside for more desperate times. We saw this phenomenon happen at the beginning of the decade during and after the crisis when bank deposits were on the rise as consumption was showing few signs of recovery on account of changed consumption behaviors.
The key to success for these exceptional central bank measures is to apply them on a limited period of time. The longer they last, the higher the risk of inflationary spike and currency devaluation. This is why it is critical that the current disease is defeated as quickly as possible so that we go back to work and shopping.
There is only so long central banks can pay our wages out of thin air.
Have a nice weekend!
