World economy on the verge of a liquidity trap

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The outgoing Governor of the Bank of England Mark Carney has warned that the central banks world over are running out of monetary tools to fight recession as the conditions of global economic downturn further deteriorate. He warned that the world could head into a liquidity trap should the central banks overstretch on extending loose liquidity policy beyond certain point. He further stated that at this point policy tools will be more effective in combating recessionary conditions and that the governments should now look at increasing public spending and relax taxes to deal with the situation.

The last few years have been a period of turmoil for the global economy, bad news and economic weaknesses emanating from major economically important geographies across the world has had a telling impact on the global economic sentiments as well. The first of these series of events that had their negative impact was in 2016 when the United Kingdom via a national referendum decided to separate itself from the European Union, known now popularly by the term Brexit. The situation in the United Kingdom and the larger European Union post that announcement has been that of acute political and economic turmoil. The severance of economic and business relations that had developed over several decades between both sides now were on the verge of falling apart, with the risk that business activities across Europe would be severely impacted. Aggravating the situation was the attitude of politicians from both sides who, despite the widespread understanding of the likely consequences, were unable to agree on a deal which would alleviate and ameliorate some of the damaging effects of the event, making the situation more uncertain and anxious for the businesses across the region and public at large. The consequences of the above were that the economic conditions across Europe remained depressed for a fairly long period of time.

The second event was the slowdown of the Chinese economy. The Chinese, after decades of strong economic growth, have now been able to place themselves as the second-largest economy of the world. In the process, they are now the world’s largest manufacturers and also the largest consumer of primary goods in the world. During the past few years due to cyclical effect and also some policy decisions the Chinses economy has been facing recessionary conditions. As a result, productive activities in the country has slowed down, which again consequently is putting pressure on the global prices of many of the primary commodities. This situation thus was not only recessionary for the Chinese but to a lot of other economies who are heavily dependent on trade with them.

The third and the most potent of the situations affecting the global economy is the ongoing trade war situation between the United States of America and China. The United States has been accusing China of following a regressive and unfair trade policy towards it and also trying to steal American intellectual property, thereby harming the interests of American companies who deal with China. As a response, it started to impose high tariffs on the import of Chinese goods into the United States. The Chinese, who initially responded by imposing counter-tariffs on American imports, were the more adversely impacted among the two warring parties. China, which is already the world’s lowest cost manufacturer, now stated to face the prospect of excess inventory with the consequence that the manufacturing sector in the country started to curtail its activities despite the country facing internal recessionary conditions.

The combined effect of the above and the festering hostile conditions in the middle-east have been putting significant downward pressure on the world economy. The problem is even more aggravated by the fact that there is no coordinated effort to deal with this global phenomenon. Each central bank, excepting for a few large ones, has only a limited impact on the global economy and their policies are often guided by local factors rather than global factors. Hence it is quite possible that a central bank in one geography may adopt an expansionary economic policy while in another geography a central bank may be adopting a tightening of its monetary policy. The problem is aggravated more in case of large economies like that of the United States and its impact on the worldwide money supply. It has often been observed that whenever there is an interest rate decline announced by the Federal Reserve of the United States, the world markets are flooded with surplus cash, upsetting the local money supply dynamics of many countries, prompting many countries to make their monetary policy announcements in synchronization to that of the federal reserve.

In the recent past, because of the prevailing economic conditions in many of the large countries, their central banks have resorted to quantitative easing almost simultaneously. This overflow of cash, while directed towards promoting economic revival of their domestic countries, have started to have a telling effect on the rest of the world economies which are not faced with similar conditions as that facing the larger countries. The phenomenon, which in economics is called Liquidity Trap, has now reached a critical point where any more quantities easing could have a disastrous effect world over.

In economic theory, the available tools to intervene in the hands of a country to bring about desirable changes in their economy are segregated into two broad groups. The policy tools relating to manipulations of money supply in the economy are grouped under the monetary policy and rest all tools are grouped under fiscal policy tools, with the governing authority of these tools remaining with the Central Banks for the Monetary policy tools and with the Government for the fiscal policy tools. The monetary policy tools have a very limited effect and, more often than not, are only effective in countering any temporary anomalies affecting an economy while fiscal policy tools have a wider role in promoting growth, development and creating employment in an economy.

The current situation as is being described by Mark Carney is more like an end of wits for monetary policy tools in tackling the global downturn. The risks of an even deeper global economic downturn could get worse in the near future if Governments do not act fast to tackle this deteriorating phenomenon.