The problem
Further expansionary monetary policy has become rather ineffective in the overdeveloped world because banks are capital-constrained rather than liquidity-constrained and because liquidity spreads in financial markets that bypass the banks have shrunk remarkably. Remaining spreads between sovereign debt instruments and assorted private securities of similar maturities can now be rationalised quite easily as reflecting just differential default risk. Until the banks get significantly more capital on their balance sheets, quantitative easing, credit easing and enhanced credit support are examples of pushing on a string.
The banks will take the liquidity offered and redeposit the bulk of it with the central bank again rather than lending it to the private sector or purchasing more risk financial instruments. Low official policy rates (and the expectation of the official policy rate being kept at a low level for a further significant period of time) will help recapitalise the banks. So will the quasi-fiscal subsidies most central banks have been channelling into the banking system through the favourable terms offered by the central banks to the private banks in their transactions, facilities etc., but such gradual recapitalisation through wide margins on low volumes of lending is slow and could lead to a re-run of Japan’s lost decade for much of the G7.
Further expansionary fiscal policy is likely to be ineffective in most of the G7 countries (possibly excepting Germany and Canada). This is, first, because households are short of capital and overly indebted and, second, because any further increase in short-term fiscal deficits is likely to undermine confidence in the sustainability of the fiscal-financial-monetary programme of the state.
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