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The Ultimate Central Bank Debate: Fiscal Austerity or Further Stimulus?

A Central Bank’s stated goal is to manipulate monetary policy in such a way that the economic result is steady growth, low unemployment, and contained inflation.  In order to create this perfect balance in the economy, a Central Bank manipulates the supply of money in the economic system.  If the economy is slowing down and needs a jump-start, the Central Bank simply uses one of its many weapons to increase the money supply. If the economy is growing too fast, and inflationary threats begin to rise, a Central Bank simply uses one of its many weapons to decrease the money supply, which in turn causes the economy to slow down, which in turn softens inflationary pressures.

This continual money supply manipulation, in order to create a positive economic environment, is a high science.  The most brilliant minds alive today disagree on exactly how this should be done—when exactly money supply should be increased and when exactly it should be decreased.  Perhaps the biggest debate currently raging among Central Banks is whether CB’s should begin to tighten monetary policy or whether accommodative measures should remain in place.  Let’s break the argument down.

In 2008, the Sub-Prime Mortgage Crisis erupted in full fury and threatened to destabilize the entire global financial system.  In order to fight off a complete economic meltdown, Central Banks gathered together in unison around the globe and slashed short-term interest rates to historically unprecedented lows. This unified economic front was successful and a complete meltdown was subverted.

In March of 2009, the recession began to bottom out in the United States, U.K. and Europe, and economies began to slowly grow again.  Thus, Central Banks began talks of when it would be proper time to begin tightening monetary policy.  The fear most economists have is that if monetary policy is left too loose for too long, inflation will result.  Thus, as an economic recovery becomes self-sustaining, accommodative measures should be slowly removed and monetary policy should be gradually returned to normal pre-crisis levels.

Well, the exact timing of when to do this is very debatable.  We basically have two camps right now.

“We Need To Tighten Policy!”

Jean-Claude Trichet, the European Central Bank President, is the Central Bank leader leading this rally cry. Trichet has outspokenly called for industrialized nations to begin the tightening cycle.  His fear is that if policy is left loose, market participants will begin to fear the fiscal budgetary imbalances of governments, and they will begin to demand much higher interest rate premiums in order to hold government debt.  If this happens to a high enough degree it becomes impossible for a government to finance its debt and it could be in danger of facing sovereign default. Thus, Trichet believes Central Banks must begin tightening monetary policy in order to reassure market participants by exhibiting responsible fiscal behavior.

“Further Quantitative Easing Measures May Be Needed!”

Ben Bernanke, the Federal Reserve Chairman, is the Central Bank leader leading the opposite rally cry.  While testifying before members of the senate on Capitol Hill recently, Mr. Bernanke made it clear that the Federal Reserve may not only continue to leave loose monetary policy in place, but they may actually provide even further liquidity injections into the economy.  The reason is simple.  The economic recovery has hit a major wall.  Growth is beginning to slow noticeably, and Mr. Bernanke is worried that the economy may slip back into a second recession if the slow-down gets too severe.  A double-dip recession like this could be disastrous for the economic future of America.  Thus, he is willing to inject yet another round of stimulus into the economy in hopes of reviving it and bringing it back to steady growth once again.

The debate among economists centralizes around the issue of a self-sustaining recovery.  If an economic recovery is not self-sustaining and monetary stimulus is removed from the system, then the commonly held notion is that the premature removal will weigh heavily on economic growth and possibly send that economy back into recession.  Thus, many economists fear what may happen in the EuroZone over the next 6 months.  Currently, the EuroZone Debt Crisis seems to be contained, but many economists are concerned that the fiscal austerity measures being adopted in the EuroZone are going to cause major problems in the near future.  Those problems will not be seen immediately; they will take several months to surface.  But as monetary stimulus is removed from already weak countries such as Greece, Portugal, Italy, Ireland, and Spain, the fear is that these economies will not be able to move forward and continue to grow, which would cause extreme volatility in the forex market.

So, Mr. Trichet and Mr. Bernanke appear to be travelling much different economic paths at the moment.  Although there are viable arguments on both sides of this issue, time will reveal which Central Banker is right.

 

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