So now they start easing credit.
Five years after an epic spree of reckless mortgage lending in the U.S. sank the global financial system, U.S. banks are healing relatively well, thanks to aggressive rate slashing and money printing early on by U.S. central bankers.
That’s a big reason the U.S. recovery, though halting, shows signs of staying power.
But the rest of the global economy is now slowing again. There are multiple causes, but as the U.S. banks have gotten back on their feet, China and Europe are still digging out from piles of bad debt. That’s made it tougher for those banks to extend new loans, which puts a serious damper on any economy.
So the central banks in Europe and China on Friday announced moves to ease credit—hoping to reverse the recent slide in economic growth.
Those moves come pretty late in the game, though, which means they may have limited impact. Here’s why:
How, exactly, does cutting interest rates help an economy grow?
An economy is made up of four main components: government spending, exports, investment and personal consumption (aka people buying stuff). Much of the growth in all four categories is financed with borrowed money, from a government selling bonds to your use of a credit card. If you lower the cost of borrowing, you help boost that growth.
But doesn’t printing money cause inflation?
It can, but there’s little evidence that the U.S. Fed‘s epic easy money policy is doing so. After injecting more than $3.5 trillion into the stem with three rounds of bond buying, consumer prices are rising less than the Fed’s 2 percent target and there is zero evidence of wage inflation.
In Europe, inflation has all but disappeared—less than 1 percent across the euro zone and approaching zero in some countries. That leaves Europe—already barely skirting another recession—at risk of deflation, or an ongoing drop in prices.
Not only is deflation a growth killer—because people and businesses hold off buying while they wait for things to get even cheaper—it can be very tough to reverse.
At this point, the European Central Bank will need to pump around €1 trillion (1.2 trillion) into the financial stem to boost inflation, according to a Reuters poll. But it’s going to be tough to get Europe’s politically fragmented central bank to agree on such a target.
Ironically, fears of inflation—especially in Germany—have been a prime reason the ECB has been so slow to cut rates and pump cash into the system. Many Germans also oppose easy credit as a “bailout” of the weaker peripheral euro zone economies.
So why is China cutting rates? Isn’t its economy booming?
European officials would kill for even half of China’s growth in gross domestic product, now expanding by more than 7 percent. But that pace of growth is slowing—for many of the same reasons.
To offset the impact of the Great Recession, China unleashed a massive borrowing and spending program, investing trillions of dollars in new roads, railways, airports, power plants, high-rises and other infrastructure to keep up with its expanding economy.
But in some places, China overbuilt. And much of the borrowed money, funneled to politically connected state-owned companies, went to pay for projects that aren’t profitable. Those loans will likely never be paid back.
Friday’s cut in the central bank’s rates will help ease the hangover from those bad debts for big state-owned companies. But it will do little to help the smaller firms that rely on China’s so-called shadow banking system for credit, according to Capital Economics’ chief Asia economist, Mark Williams.
“This does not necessarily signal that policymakers are going back on efforts to support smaller companies, or giving up on ‘targeted easing,’ but they apparently feel larger firms are now in need of support too,” he said in a note Friday.
What if all this rate cutting and money printing doesn’t work?
For that, you’ll need to ask Japanese Prime Minister Shinzo Abe. Japan has been printing money since 2001 to try to revive an economy that’s been on life support much of the last two decades.
Elected two years ago to fix the country’s economy, Abe promised to unleash “three arrows”—massive government spending, a torrent of money from the Bank of Japan and a series of reforms to promote economic growth—including regulations and trade barriers that protect companies and industries form competition.
Interest rates in Japan have been close to zero for two decades as the country has slipped in an out of recession and coped with periodic bouts of deflation. Despite great hopes for Abe’s three-pronged plan, Japan’s economy remains stuck in recession this year.