Restoring confidence

There is a lot of money in the world economy currently (rising monetary bases worldwide, quantitative easing, declining interest rates – see Graph and Table below - click to get a better view). However, none of the newly created money has had any effect on restoring confidence or economic growth.

The investors are in a lock-down, they invest into safe assets with low yields which is a typical sign of an uncertain environment. What is there to be done in order to unblock the money holdings of banks and institutional investors and make them move it into undervalued assets and equities? Once the investors start investing, money will start flowing into the economy – the government can only do so much to try and create incentives for an upsurge in demand, but so far, their efforts remain futile. Only an increase in confidence and reducing of uncertainty will work towards releasing the vastly created money into the system. Once banks and high profile investors feel safe enough to start investing again and supporting more and more projects, the money will start flowing back to the businesses. This will incentivise businesses to invest into new production which will finally increase their earnings and eventually the businesses will start hiring again. Decreasing unemployment rates will work towards increasing consumer confidence and as more jobs are created, more people will be bringing home higher incomes. At first the consumers, still careful, will start paying off their mortgage and other debts, piled up during the crisis, and after a while they will feel confident again to start buying consumer goods. The recovery, like everything in economics (except panics), is a slow process and one needs to be patient in order to see its full effects. Investor and consumer psychology plays an important role in recovery, just as much as it does in a boom. The same forces operate, only in inverted ways.

Having all this in mind, what is there to be done in order to boost confidence? It’s hard to say for sure, as every economy is different and there is no ‘one size fits all’ approach, but there are some things that should be considered.

The first thing to focus on is the source of major uncertainty in the world economy currently – the eurozone and Greece. The Greek debt should be restructured and if necessary Greece should be allowed to default. Before doing that the rest of eurozone countries should somehow be protected from their exposure to Greek debt – unfortunately, the only way to do so is through the EFSF, which bears with it a lot of unwanted consequences – see previous blog post. The policymakers still haven’t found ways to resolve this important issue and are hoping that something will happen that will somehow restart growth and resolve them of their worries. In an unlikely event of that happening, there are things to be done in order to boost confidence, but these are no short-run solutions. Since the politicians were so impatient to call for the end of the previous recession, they are now even more aggravated that nothing they do seems to be working. 

Uncertainty is rising high due to the inability of the policymakers to provide plausible solutions. This is becoming even more noticeable in the European banking sector which is seeing an increase in overnight deposits placed within central banks (see graph below). The banks feel uncertain and don’t know where to place their excess liquidity. They don’t want to borrow between each other under rising fear of default of various banks exposed to sovereign debt. 

This is obvious evidence that the banks aren’t illiquid, they are just uncertain and don’t know where to invest their money in as they are constrained from all angles (previous blog). They chose the safest option of putting the money overnight within the central bank and getting a safe return. The central banks should start thinking how to discourage banks from leaving too much overnight deposits by charging banks for placing their deposits with the central bank overnight. Giving banks negative rates for overnight deposits is an unconventional method but it might just work. However, there is no guarantee this will drive them into increased business lending, as uncertainty will still be high and confidence low, despite low interest rates and new lines of quantitative easing. Liquidity is present in the system, but is not encouraging lending.  

This means that something else needs to be done to move the excess liquidity into other assets and loans. Printing new money and using it to buy Treasuries and clearing banks’ balance sheets off from bad assets isn’t going to start growth or employment. It is more likely to devalue the currency and monetize the debt while having a huge inflationary effect. Therefore, besides discouraging banks to keep money at the central bank there is not much to be done via monetary policy to increase investor confidence – what is needed is a boost of confidence via stabilizing the system and creating incentives to increase production and therefore increase demand. 

What should be done

The first necessary policy is keeping taxes low long enough to create a credible environment for businesses expectations. This can be done only by credibly committing to keeping the budget deficit low (fiscal consolidation) so that businesses don’t create expectations of increasing future taxes. The EU economies and the US should seriously consider introducing flat tax, or at least a tax reform to reduce marginal tax rates on investments, corporate profits, capital gains and personal income, while broadening the tax base. Tax incentives should also be created to stimulate investments through, for example creating low-tax entrepreneurial zones to attract and encourage businesses for new investments and hiring. Another good way to stimulate investments would be eliminating taxes on capital investment in order to encourage businesses and manufacturers to start buying new equipment. Although this might generate an initial loss in revenues, it will pay back through newly created demand for investment into equipment and a boost of sales and earnings.

Second, any existing employment regulation should be reduced substantially and it should be made a lot easier for businesses to hire. One way to do this would be to eliminate income tax on newly employed for the first year or two. This would particularly be aimed at young people seeking their “first job”, in order to reduce high levels of youth unemployment. Businesses would welcome a cut in hiring costs. However, they can only start hiring if they start producing and investing. Therefore, the tax incentives have to come first in order to support business production. This will eventually be followed by higher production levels (higher supply) and will lead to firms start hiring more. With more people having new, safe jobs, they will increase their consumer goods consumption which will all together lead to a rise of aggregate demand. What is important to note is that this is a gradual process and one needs to be patient in order to see its full effects. A credible promise of fiscal sustainability, signals of tax incentives for businesses and changes in the labour market will send positive reinforcement to banks and investors and will work towards increasing their confidence. 

The final step, from the US perspective, should be to stop blaming China and their ‘deliberate’ currency devaluation on the US current account deficit. It is not the Chinese fault that a vast majority of US companies decided to cut costs by moving all the production to China due to smaller labour costs and higher overall productivity. This is a perfectly welcomed move by a profit maximizing company – it will choose the best way to decrease costs and increase revenues by still maintaining the quality of their product or service in order to maximize their profit – Apple is the perfect example. The politicians and economists should therefore lay off China and start thinking about the inter instabilities of the US system of why the US current account is so large. The current account deficit by itself isn't a problem when the capital inflows are used to finance investments instead of consumption as it will boost production and increase growth. When the capital inflows are used to finance consumption, this will very likely be used to finance an asset price boom. In addition, the US received a lot of capital inflows from other countries’ central banks instead of private investors which also weakened its trade position. Another way to think about the deficit was to take it as an effect of globalization – the US will continue experiencing high capital inflows as it did before the crisis as it is considered a country worth investing in. The savings of surplus countries will continue to flow in the most productive assets, such as the ones in the US. For further insight on the subject I recommend an excellent explanation of the US current account deficit by Ben Bernanke in 2005.

In short, the US should stop inducing protectionist policies, remove any barriers to trade (while not imposing the tariff for Chinese goods which will only start a trade war with China – something neither of the countries want) and promote free trade to increase specialization, competition and benefit from economies of scale. Every crisis so far resulted in a high trade contraction worldwide (see Reinhart and Rogoff) and it was not until trade was restored to previous levels that the economies started to grow again.