You will often hear the term "new money" when it comes to economic stimulus, but what does it mean, and how does it work? More prevalent in times of financial hardship, this is a means of supporting the economy and maintaining price stability. While quantitative easing, the direct creation of new money to purchase bonds and other assets, is perhaps best known, governments and central banks also use other methods.
Lowering interest rates
Interest rates are a very basic but effective tool for controlling investment and overall economic activity. When an economy is struggling, a reduction in interest rates will discourage saving (by reducing rates) and encourage spending and borrowing by reducing the cost of finance. The major problem with using interest rates as the main lever to control economies is the time lag for the optimum impact.
Quantitative Easing
Often referred to as QE, this is the process by which the money supply is increased, with new funding used to purchase government bonds and other financial assets. This directly injects liquidity into the financial system, lowering interest rates and encouraging spending with the broad aim of stimulating economic growth. Unfortunately, the introduction of new money can also stimulate inflation, leading to price rises for goods and services.
Providing loans and credit to the financial sector
As we saw during the pandemic, governments and central banks created new money to provide additional loans and credit to banks and financial institutions. This not only enhanced their liquidity, avoiding the collapse of the entire financial system, but also encouraged them to continue lending to businesses and consumers – supporting the economy and laying the foundations for an eventual recovery.
Direct fiscal stimulus
While not seen so much during the actual pandemic, more after the event, direct fiscal stimulus saw new money used to fund infrastructure programs, public works and social projects. This led to job creation, increased consumer spending and stimulated economic growth. As this was capital spending by the government, it did not increase the debts of companies and individuals, although it did lead to a sharp spike in national debt.
Supporting businesses and industries
As a government and central bank, there is a need to take a long-term view on spending today and the value tomorrow. For example, providing subsidies, grants or low-interest loans to businesses in specific industries during times of hardship will help prevent bankruptcies and job losses – and encourage economic recovery. Even though non-repayable finance made available to companies and individuals may seem like money down the drain, the long-term economic benefits are often far more significant.
Social welfare programs
Again, as we saw during the pandemic, the government injected significant new money into the system to enhance social welfare payments relating to unemployment benefits and everyday living expenses. This move supported families during the worst of the pandemic and fuelled consumer spending, which eventually helped stabilise the economy. The positive impact on individual finances and their mental health is often underappreciated.
Currency stabilisation
On 16 September 1992, the UK government was forced to withdraw sterling from the European Exchange Rate Mechanism (ERM) after a “run” on the currency.
In order to support the exchange rate, the UK government had been forced to increase interest rates to an intraday high of 15% and buy billions of pounds in the currency markets. This prompted the infamous billion-dollar bet by George Soros, who, like many traders, did not believe the UK government could maintain such high interest rates for long. They were right; the announcement to leave the ERM saw a double-digit fall in sterling and the dawn of a new era for the UK and Europe.
Under normal circumstances, global central banks come together to support struggling currencies and are often successful. This is not a long-term solution but a short-term reaction to volatility. However, the ERM scenario was very different and damaging to the UK economy, currency, and reputation.
Summary
While the introduction of new money can offer an element of short-term support to a struggling economy, there are numerous risks and considerations, such as:-
· Stimulating inflation
· The creation of asset bubbles
· Increased public debt
Even though other factors were involved, the recent introduction of new money to support the UK economy was successful. However, it stimulated inflation, created asset bubbles, and increased public debt. Is this an example of short-term gain but long-term pain?