Analysis of the monetary and fiscal policy tools and their effectiveness

Introduction

Historically speaking, there are two major perspectives to look at the economy. On the one hand, the “classical” view was developed to analyze processes that occur on the “free” market. Primally, its attention was on focused on the issue of economic growth. However, later on it shifted its focus mostly to the issue of efficiency (De Vroey, 1975). In its basic form, classical theory states that the economy should not be interfered with by politicians because it is able to regulate itself without government involvement. On the other hand, Keynesian view is based on the on the state has a role to play and government actions may (and indeed should) affect the level of aggregated demand (Blinder, 2002).

More specifically, fiscal policy, administered by central government, consists of setting the levels of taxes, allocating government’s expenditures, and transferring resources across the economy, e.g. helping the poor through redistribution. The central bank, on the other hand, conducts monetary policy through interest rate and money supply management. To influence the latter, it may influence treasury bond availability, and also when needed may intervene to stabilize the financial markets. Both fiscal and monetary policy can be invoked to ensure economic stability, defined usually as by low unemployment and stable inflation.

Hence, economists have long argued if (and if so - to what extent) fiscal and monetary policy can influence the economy. Most economists believe that this influence can indeed be substantial. In this paper, I will attempt to examine the past instances of fiscal and monetary policies’ effectiveness, as well as compare it to the actions currently undertaken in Poland, United Kingdom and Germany to mitigate the economic fallout of the pandemic.

Fiscal and monetary policy through the historical lens

The Great Depression

The first historical event that I would like to analyze is the Great Depression – the deepest economic crisis of the 20th century. The debate about the causes of the Great Depression is still alive, although one of the main reasons was surely the fact that real government spending dropped significantly hence lowering the level of aggregated demand (Romer, 1992). Also, there were significant changes in how the economy was operating. For example, due to the fact that demand for goods dropped, it was very difficult to repay debts that were incurred during the War.

The start of Great Depression is marked by the so-called “Black Friday”, the 28th October 1929 when Dow Jones Industrial Average declined by 13% overnight – a biggest daily decline to date. During the Great Depression United States’ GDP was declining at a large pace of up to -13% in annual terms which resulted in overall GDP contraction of over 25% relative to pre-crisis levels. Unemployment, which during the 1920s the unemployment was oscillating around 5-8%, skyrocketed to 25 percent in the wake of the crisis. Furthermore, monetary policy is thought to have contributed to the outbreak of the Great Depression as well. Indeed, after World War I the threat of persistent inflation emerged. Federal Reserve, in order to combat it, was raising the discount rate and the economy did not react as fast to these changes as it was predicted which it resulted in next increases (Romer, 1992).

Economists have long debated what was the main source of recovery after the Great Depression as well. According to Romer (1992), monetary policy may have played a role in the recovery after the Great Depression. Gold inflow caused partially by policy and partially by external events contributed to a decline of real interest rates and thus encouraged investments. On the other hand, some economists claim that the actions taken by Federal Reserve were not appropriate. In 1936 the reserve requirements were raised and therefore money supply was decreased due to the fact that bankers limited the lending because they wanted to keep reserves above the required level. The inappropriate contractionary monetary policy made the situation worse and hampered the recovery after the Great Depression (Wheelock, 1992). Such contractionary policy was used to avoid inflation because people did not suspect that occurring deflation may as well lead to significant disruptions. When deflation reached 8% annually, it raised real interest rates and further discouraged investment spending therefore caused more economic damage. (Bordo, Goldin & White, 1998).

The stabilization of the economy using fiscal policy was not easy due to the fact that before the Great Depression was the first crisis of that magnitude and fiscal authorities were not used to intervene before. At that time automatic stabilizers were not sufficient to balance the situation (Bordo, Goldin & White, 1998). Indeed, opposing some members of his party president Hoover was aiming at balanced budget. Firstly, Hoover increased taxes to boost government revenues. Also, government expenditures such as bonuses for veterans, were cut, he outplaced an additional source of their income which resulted in lower personal spending. In spite of the contractionary fiscal policy, the deficit rose. (Bordo, Goldin & White, 1998). In a similar spirit, the Secretary of the Treasury Andrew Mellon advised that it would be the best not to intervene too much and let the labor, stocks, farmers and real estate collapse because the economy would best balance itself without any help (Hoover, 1952, 3: 30). However, Franklin Roosevelt introduced a plan called New Deal which was aimed at stabilizing the situation by government’s active interference into the economy. Thanks to a series of programs the economy efficiency was improved. The first part of the program focused on creating new workplaces and helping the poor and elderly. The second part was aimed at supporting production and agricultural sector. New regulations were introduced which were aimed to improve the financial system and avoid a similar crisis in the future.

The Global Financial Crisis of 2007-9

The next event that I would like to look at is the Global Financial Crisis of 2007-9. In the early 2000s there was a the real estate market grew rapidly and various financial products, including the mortgage backed securities, were introduced. On top of that, banks were lending a lot, including to high-risk individuals. The house prices were growing very fast creating a mortgage bobble which burst in 2007. Plenty of high-risk house owners were either not able or willing to repay the debt they incurred. This had led banks to severely restrict lending, causing a downward spiral of home prices. People were often left with bank credits which were much higher than the value of their houses and could neither resell the house nor repay the debt. This situation caused bankruptcy of many banks including Lehman Brothers and the stock market dropped worldwide.

This time, however, the United States’ government took a very different policy approach. To help the struggling banks the government bailed out many of them, announcing $700 billion bailout program which in fact resulted in much higher government commitment of $16,8 trillion (Collins, 2015). Real spending was not fully disclosed to avoid even bigger panic and distrust to financial institutions. In 2008 on October 3rd the Emergency Economic Stabilization Act was introduced. It created Troubled Asset Relief Program (TARP), which was aimed at repurchasing the so-called “toxic” assets, with the mortgage-backed securities to the fore. Later, the program was changed so the government could purchase capital in banks (Fratianni & Marchionne, 2010). Inititally, the authoritized amount was $700 billion but ultimately the amount dedicated to buy bank’s equity was reduced to $475 billion. It included money to stabilize banking institutions, programs to restart credit markets, aids for struggling families, money to stabilize AIG and auto industry (TARP Program, 2016)

Nevertheless, it has to be noted that such actions having positive short-term consequences may lead to severe long-term economic disruptions, such as huge government debt, unbalanced budget and budget deficit. However, these actions were needed to avoid the collapse of the financial system in the US and beyond.

Furthermore, US’ government decided to use more expansionary fiscal policy to avert the emergence of a deflationary spiral. More specifically, they introduced American Recovery and Reinvestment Act of $787 billion stimulus package in 2009. It included $288 billion tax cuts and increased expenditures. The benefits were distributed and $150 billions were allocated for sectors such as education, energy and transportation (Liborio, 2011). These actions led to huge government deficit afterwards which needed to be balanced. However, without these actions the consequences on economy could have been even more severe.

Monetary policy was actively used as well and included significantly lowering interest rates. From 2007 to 2008 the Federal Reserve lowered interest rates from 5,25% to 0,25% (Mishkin, 2009). It was supposed to encourage firms to invest, hire new workers and private people to buy. When the unemployment rate was still remaining on a high level the Federal Reserve started to buy Treasury bonds together with mortgage-backed securities – a process called Quantitative Easing (Liborio, 2011). Such expansionary policy was aimed at increasing the money supply by lowering long-term interest rates. Also, tosupport liquidity Fed cooperated with European Central Bank and Swiss Central Bank.

The Great Financial Crisis thought us that more comprehensive risk analysis is needed – in the banking sector and beyond. Banks have to be much more careful assessing risk and their capabilities. Another very important thing is to be transparent with people. After the crisis, the Dodd-Frank act which was aimed to address the issue of too risky banking practices was introduced.

COVID-19 crisis

Coronavirus caused changes in both supply and demand which combined may have resulted in a huge economic crisis. First of all, there are several significant changes on the supply side. At the beginning, the first disruptions were caused by Chinese lockdown. Many countries rely on production in China therefore when for approximately two months of the Chinese shutdown, the whole production stopped, it was exceptionally damaging for the global economy. Having GDP worth $14200 billion in 2019 China is the second biggest economy after USA (China GDP, 2020). Lowered economic activity influenced also other sectors such as transport tourism and some sectors of entertainment industry. The World Tourism Organization (Impact assessment of the COVID-19 outbreak on international tourism, 2020) reports state that there have been 67 million fewer international tourist arrivals, $80 billion loses in export and all the destinations introduced some travel restrictions.

In most countries there were some restrictions that were meant to prevent the virus from spreading which lead to lowered economic activities. Many businesses collapsed. Due to limited business activities and bankruptcy of significant number of companies, a lot of people lost their jobs. In the USA the labor market reported 14,7% of unemployment in April 2020 (U.S. unemployment rate: seasonally adjusted April, 2020).

In uncertain situations companies tend to limit their investments. People who were recommended or ordered by governments to stay home also spend less. Firstly, in uncertain situations private people tend to be save more and therefore spend less. Secondly, even if they would like to go out, they cannot due to the lockdown. Moreover, people who lost their jobs have less income which equals less money to spend. The economic activity slows down.

The situation is being often compared to the Global Financial Crisis. The crisis affects many sectors not only one as it was in case of the Subprime Mortgage Crisis. The current unemployment rates are the highest since 1920-30s. Stock Market also suffers. Dow Jones Industrial Average dropped from 29000 points in the February to 18600 points in March. The complexity of the disruptions suggests that it is being the biggest crisis since the Great Depression. Understanding that, governments and central banks take actions and support the economy using various tools. Every country approaches situation in a slightly different way.

USA

The government took a number of steps to minimize the effects of the lockdown on the economy. First, they introduced direct support to individuals, loans for struggling businesses and increased financial support for various industries. On March 13 national emergency was declared, which allowed the use the Stanford Act. It is predicted that $50 billion will be spent in emergency funding; $8.3 billion was distributed for emergency coronavirus aid package. Families First Coronavirus Aid Package was introduced to provide tests to uninsured, provide sick leave, medical leave, family leave and support the unemployed. The Coronavirus, Aid, Relief and Economic Security Act (CARES Act) was signed to redistribute approximately $2.2 trillion, including $150 billion financial assistance for the state and local governments. Finally, it launched lending fund for businesses, states and cities and support to taxpayers and payments for children (State fiscal responses to Coronavirus, 2020)

Monetary authorities responded decisively as well. Federal Reserve has resumed the purchases of the Treasury bonds and mortgage-backed securities, a process known as QE. Furthermore, it has cut the fed fund rate from 1.75 at the beginning of 2020 to 0.25 (United States Fed Funds Rates, 2020). Moreover, the Fed encourages banks to lend by providing direct lending with a discount window at 0.25%. The regulatory requirements are temporarily relaxed and the access to credits for companies is much easier (Łukaszewicz, 2020). Fed recognizes that thanks to loans companies are able to cover the losses and survive. Special purpose vehicles were created to lower the risk and stabilize the financial market. Fed is also helping to finance the CARES Act by transferring $454 billion to increase the financial leverage (Dorn, 2020).

Public health and safety, local governments, private consumers, households and businesses are being heavily supported in the biggest economic intervention since the Global Financial Crisis of 2007-8. Such an aggressive fiscal and monetary response is needed to mitigate the consequences of a massive economic shock which resulted in massive layoffs and faltering demand. Expansionary fiscal and monetary policy focusses on the short-term perspective and due to that increases supply and demand. Even though it increases government debt it is needed because it helps to fight the current crisis and hopefully decrease long term effects of the financial shock.

United Kingdom

United Kingdom was a country that introduced the lockdown relatively late. However, after realizing how serious the situation was, British government introduced the lockdown and responded with policy initiatives that are supposed to help British economy. First of all, the COVID-19 Business Interruption Loan Scheme was introduced. It is supposed to provide support to small companies by providing them loans with the first year free of interest. Loans for small and medium companies with 100% Government Guarantee were introduced. Also, now it is possible to defer debts in situation of financial difficulties and to defer income tax and VAT payments. Sectors that suffer the most such as retail, leisure and hospitality are exempted from paying business rates until March 2021. Funding schemes for local authorities were introduced to support small businesses: a £25.000 grant can be applied for by firms from the retail, hospitality and leisure sectors. Large firms are supported by Covid Corporate Financing Facility which purchases commercial papers of up to one-year maturity. Self-isolating may use different form of leave instead of sick leave and self-employed will receive for three months grants (Regulatory, monetary and fiscal policy initiatives in response to the COVID-19 pandemic, 2020).

Similarly to Fed, Bank of England introduced expansionary monetary policy. On 11 March interest rates were cut to 0.25%. BOI announced purchases of government bonds and sterling non-financial investment-grade corporate bond purchases. There was also announced Term Funding Scheme with additional incentives for SMEs which offers funding with rates close to Bank Rate. Bank of England tries to support money liquidity by cooperation with central banks of countries such as Canada, Japan, Swiss, ECB and Fed. Furthermore, reserves are being lend in exchange for less liquid assets (Regulatory, monetary and fiscal policy initiatives in response to the COVID-19 pandemic, 2020). The monetary policy is set to maintain 2% inflation level to keep price stability. The BOE actions are supposed to support households and companies and reduce long-term negative effects such as increased unemployment or business failures (Bank of England, 2020).

Poland

To fight the coronavirus Polish Government is spending almost 312 billion zł. The Polish program consists of four so-called Anti-Crisis Shields and a Financial Shield. The first two shields announced on 31 March and 17 April 2020 included solutions such as exemptions from social security contributions, tax credits or deferrals, additional financing for workers, grants for self-employed, financial assistance for transport sector, a single loan for micro companies and self-employed (Grygorcewicz et al., 2020). Later on, Financial Shield 3.0 introduced 900 million zł support for businesses and clarified previously-implemented regulations. On top of that, an additional tax on VOD platforms were announced. Lastly, Anti-Crisis Shield 4.0 included in particularly more support to public entities, support for creditors who are in difficult situation, credit payments reliefs or credit suspensions (Dopłaty dla firm, wakacje kredytowe. Kolejna tarcza przyjęta przez Sejm, 2020). Finally, public investment program was introduced to stimulate the economy (Tarcza antykryzysowa - Tarcza antykryzysowa, 2020).In the Financial Shield program 100 billion PLN has beenallocated to support small, medium and big corporations. Nevertheless, the Polish government is, fiscally speaking, in a slightly more difficult situation than for example Germany whichin recent years was able to achieve the budget surplus. Despite the fact that during past years the GDP growth was relatively high the government Poland did not manage accumulate any budget surpluses. However, the public debt was on a downward path and created a room for the current borrowing.

The National Bank of Poland cut the reference interest rate was from 1,5% first to 1% and then to 0.5%. On top of that, in order to boost liquidity in the banking system the reserve requirements were lowered from 3,5% to 0,5%. Moreover, to maintain liquidity the Polish central bank offers overnight loans to banks which are backed by the government (Narodowy Bank Polski - Internetowy Serwis Informacyjny, 2020). Also, for the first time the quantitative easing was introduced. Government bonds are being bought up which helps to finance spending on thementioned “shields”.

Conclusion

Unlike in the past, now economists seem to agree that both fiscal and monetary policy have a big impact on the economy and areespecially crucial during a crisis. Disruptions in the economy during Financial Crisis of 2007-9 were caused by ineffective financial system. Comparing to that the current situation at the same time changed both supply by stopping some industries from operating and demand by putting citizens in the lockdown. The complexity of the situation could be compared to the Great Crisis. However, now economists know better how the economy works and governments have more tools to mitigate the adverse effects. All central banks in analyzed countries significantly lowered the interest rates and support lending which is supposed to fight the losses and help the economy on both supply and demand side. Governments take actions to support both businesses and household which is supposed to prevent the panic, reduce unemployment and stimulate the economy to avoid recession. Growing public debt may be concerning. However, the situation demands immediate reaction from the government and central banks and the collapsing economy could have much worse consequences.

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