What is this ‘monetary policy’ and is it enough to stimulate economic recovery?

RAFAŁ BILL, Liberty Programme

Monetary policy alone is never enough to stimulate economic recovery. Precisely, money alone are never enough to do anything. It has to be followed by other activities as well as common sense. History and case studies of different countries are able to teach us such ideas.

There are plenty of factors needed for successful development of  economy. However, main areas which increase a chance to do so are: budget cuts and government reforms, innovation stimulus, automatic stabilizers and development of human capital. Changes of monetary police alone are ineffective in face of the financial crisis.

Monetary policy, although in economic theory seems complicated, is rather simple. It means changing the value of money in economy. Central banks are able to control interest rates. If they are lower, then commercial banks may borrow money from central bank cheaper and then offer it to customers by lower margin. In simple words: there are more money on the market. Lower interest rates by such process increase inflation – which means that home currency has lower value comparing it to foreign ones. It is needed to pay more money to have the same amount of foreign currency. It affects balance of trade on international markets. A weakened currency is good news for exporters of goods, but usually bad news for importers and customers. However, if company which produces goods in state and then exports them abroad gets paid for them, it receives more national currency for the same amount of foreign money because home currency is cheaper. It may use these means to increase production or salaries as well as hire new workers. In such a manner economy of state would develop.

On the other hand, improper monetary policy may cause negative effects and even trigger economic crisis. First of all, as was said aboce, it has negative impact on inflation, increasing it.  Inflation means a decrease of money in a given period of time.  A consequence may be explained by case study of Zimbabwe, a South African country. There, the Inflation is so high (counted in thousands of percent) that money received by a man in the morning have practically no value couple of hours later. Central bank of Zimbabwe “produces” so much money in short period of time that value of it decreases at a glance. The bank does not even print the money – now the economy is matter of numbers in virtual reality.

Second, monetary policy may cause a negative effect called liquidity trap. Money has value if it is invested and not keeped at home. The liquidity trap is a situation when people do not buy financial instruments but aim only at keeping money as cash. In such a situation money does not work, companies are not able to gain external capital and economy falls down.

Third negative consequence of improper monetary policy is a situation when cheap money create bubbles. It happened a few years ago in the US – a burst of bubble on estate market commenced the global financial crisis. For long time FED (equivalent of central bank in the US) maintained low interest rates. Banks gained access to a cheap capital which was offered as credit to customers. Money was used by people to increase consumption. However, such process has to reflect real possibilities of a borrower to repay the loan in future. It did not happen in the US – a value of estate start dropping as nobody wanted to buy it and commercial banks were left with worthless houses and hundreds of borrowers who were unable to repay taken credit. For financial institutes it means one thing: going bankrupt. Crisis starts.

Monetary policy is a tool that has to be used carefully. If it is used correctly, it may affect positively a development of economy. If not, it may cause negative effects which were described above. It is a powerful tool to control the economy during times when financial crisis is absent. An appearance of the latter requires additional means which were mentioned at the beginning.

Budget cuts and governmental reforms aim at decreasing of bureaucracy and tax burdens. They stimulate activities of people who have got more means to spend on consumption and investments. This is a main thing of actual Greek crisis. Despite support of the European Union, Greece is not able to recover due to demands of society to maintain social privileges, which increase deficit of public sector. A state has to implement unpopular decisions to increase effectiveness of economy during financial crisis.

Next, innovation stimulus a public support of research and development area, which creates competitiveness of economy. It does not need to be a direct instrument but may take a form of creating opportunities, eliminating barriers, encouraging companies to invest. Modern technology always wins with older ones and economy built on such base is able to compete with others. An example of such a policy is Switzerland, which is one of the most innovative economy and was able to minimize negative effects of financial crisis. The development of human capital must not be forgotten because innovations are created and used by people for people. A state has to adapt its educational system to requirements of market as well as support creativeness of society.

Last but not least, a system of automatic stabilizers is effective in times of economic crisis. A term ‘automatic stabilizers’ means preparing of policies such as income taxes or welfare spending which are flexible according to situation. For example state may support unemployed people by workshops which would be able to help them recustom their profession and find new work. It is required to compile such policies before crisis because they may start functioning in the very first moment of crisis. A disposable activity or a transfer of means is not able to improve situation. A model to follow presents Sweden, which despite crisis is quickly developing now. Serious crisis occurred there in the last decades, but Stockholm drew conclusions and prepared automatic stabilizers to minimize next potential difficulties. It has been working.

Switzerland and Sweden are examples of minimal interest rates set by their central banks to stimulate economy. On the other hand, Japan has got for long time zero percent interest rates but this decision was not able to help economy from the Far East to recover.

Various cases of Switzerland, Zimbabwe, Japan, Sweden and Greece showed that there is no universal model of recovering from collapsed economy, mainly because societies are different and so are their conditions of development. In spite of this diversity, a monetary policy combined with mentioned above additional tools are the most effective methods to go back on path of prosperity.

This article as submitted on 19th February for Project Firefly organized by CreditSuisse.