Treasury Today Country Profiles in association with Citi

ECR Research logo

Global market overview

When it comes to economics, there is no free lunch. In this month’s Market View we discuss the limits to effective monetary stimulus. We also look at the lessons that history has taught us about government intervention and examine how this could impact the handling of today’s economic challenges.

Limits to monetary policy

The US, Japan and Europe need stimulus for their economies to grow and to repay excessive debt levels – but stimulus from whom? Higher export growth might be the solution for several countries, but not for all. Some countries have to run large trade deficits to facilitate this, and no country is willing to volunteer.

More fiscal stimulus is out of the question for most countries, as they want to avoid a Greek debt crisis. All eyes are therefore on central banks as powerful guardians of the economy and financial markets, backed by an unlimited source of (fiat) currency. Unfortunately, there are limits to effective monetary stimulus – something US policy makers are more aware of than most of their European counterparts.

There are continual imbalances in all economies. In a free market economy, these imbalances are rectified by the price mechanism. The history of the 19th and 20th centuries has shown that this cycle of imbalance and rectification can, however, be accompanied by great shocks. As such, there has been increasing intervention to smooth out the cycles. Great social and political tension resulting from sharp economic decline played a major part in driving this intervention.

Theories were therefore devised (mainly by Keynes and Friedman) for making a buoyant economy grow less quickly by building up reserves. The rationale behind these reserves consisted of two elements:

  1. Building up budget surpluses during boom times, so the government had excess reserves to spend in poor times.

  2. Increasing interest rates in good times so they could be reduced in leaner times. The effect of high interest rates was more saving and less borrowing. Moreover, upward pressure was then exerted on the exchange rate for the currency in question. When interest rates were low, the opposite occurred.

How it was then

Of course, the inventors of these theories intended that the reserves spent would equal the amount earned throughout the cycle. Under great political pressure, however, this never actually happened: more reserves were spent in leaner times than were built up in good times. In practice, this meant deficits mounting far higher than surpluses and interest rates that were too low. Due to the mounting deficits, public debt rose continually; due to the low interest rates, debt positions in the private sector grew constantly and less was saved (when expressed as a percentage of the total economy).

What this actually meant was that there was increasing borrowing against future economic growth. This, naturally, was saddling future generations with the necessity to relinquish larger and larger proportions of their income for interest and repayment obligations for old debts. This could have been justified if the majority of loans had been used for investment. After all, this would have buoyed the economy in the future.

However, the majority of the debts in recent decades were actually used to increase consumption. This was inevitable, at some stage. After all, the more indebtedness increased, the greater the risk of the economy ending up in a downward deflationary spiral in the event of economic decline, let alone recession.

This can be compared with someone having have borrowed the maximum against all their assets and income (even future income), and their assets suddenly depreciating in value and their income falling. As a result, the person quickly goes bankrupt.

If this happens at a national level, the further government and private sector debts mount, the less acceptable an economic decline becomes – a recession even more so. After all, recessions are accompanied by lower incomes and depreciation of stocks, property etc. This also necessitates monetary stimulation by way of lower interest rates, at an increasingly early phase in economic decline, and fiscal stimulation by means of inflating budget deficits.

Such an approach generates a self-perpetuating spiral, however, as the stimulation entails raising the burden of debt, which in turn necessitates greater and earlier stimulation in the event of the next decline. This has primarily entailed increasing consumption: if consumption were too low, this would result in deflation and then debts would start weighing far more heavily (deflation causes a drop in nominal incomes, while interest and repayment obligations for old debts remain constant). This takes us back to the credit crisis and the current situation.

How it is now

The credit crisis actually came about because the markets considered that debts had mounted too far in relation to expected economic developments. As soon as housing prices started to fall, many loans depreciated in value, leaving banks with major losses.

The banks therefore started lending less; the economy and housing prices then declined even further and so on. Initially an attempt was made to compensate for this by significantly easing monetary policy, but it proved impossible to get lending in the private sector going again.

The only way to prevent a total collapse of the economy was therefore to inflate budget deficits enormously. Numerous studies have shown, however, that if public debt rises above around 90% of the total economy, and interest rates remain stable or increase, a negative spiral is created. The interest payable starts imposing so heavily on other government expenditure that it seriously affects economic growth. Tax revenue drops, budget deficits mount further and so forth.

Unfortunately, virtually all industrialised countries are threatening to exceed the 90% level in the coming years and some have already done so. It is therefore understandable that European countries are eager to reduce their budget deficits as quickly as possible. They are also hoping that this will largely compensate for the monetary policy. The US, where the crisis originated, is not counting so much on the latter, which is why the policymakers are urging budget deficits to be reduced as slowly as possible.


Although in the long run the Europeans might have the soundest policy (more government debt is not the solution for a crisis caused by too much debt), their economies will be more negatively affected than that of the more profligate US.

Over the coming quarters, this will contribute to a weaker EUR/USD in our view (ultimately we expect a EUR/USD at parity and lower). Furthermore, as a result of slower economic growth we expect downward pressure on US and German long-term interest rates and upward pressure on credit spreads.