Central Bank Stimulus: A Tightrope Walk for Economic Recovery

5th February 2021

In early 2021, central banks continue their aggressive stimulus measures. But what are the risks associated with this ongoing support? We assess the balance between recovery and financial stability.

As the global economy grapples with the aftermath of the COVID-19 pandemic, central banks around the world have turned to unprecedented stimulus measures in an attempt to keep the wheels of commerce turning. Interest rates have been slashed to historic lows, and large-scale asset purchasing programmes have flooded the financial markets with liquidity. Governments, too, have implemented vast fiscal interventions to prevent widespread unemployment and economic collapse. But as we stand on the precipice of 2021, one question looms large: Are central banks walking a tightrope between economic recovery and financial instability?

The term "stimulus" has been used so frequently in recent months that it has almost become a buzzword, losing some of its original meaning. In essence, stimulus refers to the tools that central banks use to inject money into the economy in an effort to stimulate demand, encourage investment, and bolster employment. But the scale of these measures has been unprecedented, and many economists are now asking whether these efforts will ultimately pay off—or whether they could lead to unforeseen consequences further down the line.

The first and most immediate impact of central bank stimulus measures is to lower the cost of borrowing. By slashing interest rates, central banks make it cheaper for businesses and consumers to borrow money. This encourages spending and investment, which can help stimulate economic growth. The result is a kind of "economic lifeline" for industries that are struggling to survive in the wake of the pandemic. Take, for example, the real estate market. In many countries, homebuyers have been able to take advantage of low mortgage rates, leading to an uptick in housing activity. Similarly, businesses have been able to access cheap credit to continue operations and expand their workforces.

However, the benefits of these stimulus measures are not without their drawbacks. The most obvious concern is the potential for rising inflation. By flooding the economy with money, central banks risk driving up prices, particularly for goods and services in high demand. The reality is that when there is more money in circulation, the purchasing power of that money decreases. This is what we refer to as inflation—a gradual increase in the prices of goods and services that erodes the value of money.

At the same time, central banks face the very real risk of asset bubbles. Low interest rates have encouraged investors to seek higher returns in the stock market, real estate, and other speculative assets. While this has been beneficial for asset prices, there are concerns that prices have become detached from the underlying economic fundamentals. Some economists are worried that the stock market could be in the midst of a bubble, as valuations for many companies have soared to levels that are hard to justify based on their earnings potential. Similarly, real estate markets in certain regions have seen sharp price increases, leading to fears of a property bubble.

Yet perhaps the most profound risk of central bank stimulus lies in the long-term consequences of excessive debt. As central banks inject liquidity into the economy, they are also encouraging governments to take on more debt in order to finance their stimulus programmes. This creates a situation where debt levels are rising at an unsustainable rate. In many developed economies, government debt is already at historically high levels. The International Monetary Fund (IMF) has warned that these levels could rise even further as governments continue to borrow to finance their pandemic response.

In the past, economists have warned that excessive debt can lead to a variety of negative outcomes. In the short term, it can drive economic growth, as government spending creates jobs and stimulates demand. However, in the long term, high levels of debt can lead to higher interest rates, reduced investment, and lower economic growth. Governments may also be forced to raise taxes or cut spending in order to service their debt, which could have a dampening effect on the economy.

The tightrope walk that central banks face is akin to the moral dilemmas posed by the great works of English literature. Take, for example, the famous tale of Dr. Jekyll and Mr. Hyde by Robert Louis Stevenson. Dr. Jekyll’s creation of a potion that allows him to switch between his good and evil personas is a metaphor for the duality of human nature—and, in the case of central bank stimulus, the duality of economic intervention. Just as Dr. Jekyll’s actions have unintended consequences, so too can the actions of central banks have far-reaching and unpredictable effects. Stimulus measures may provide short-term relief, but the long-term consequences could prove to be far more sinister.

Similarly, Macbeth, one of Shakespeare’s most enduring tragedies, explores the theme of ambition and the consequences of unchecked power. Macbeth, driven by his desire for power, commits a series of heinous acts that ultimately lead to his downfall. Central banks, in their attempt to control the economy, may find themselves caught in a similar cycle of ambition. As they push forward with more aggressive monetary policies, they risk becoming too reliant on intervention and losing sight of the need for sustainable economic growth.

But it is not all doom and gloom. There are ways that central banks and governments can mitigate the risks associated with their stimulus measures. For example, central banks can take a gradual approach to unwinding their stimulus programmes, slowly raising interest rates and reducing asset purchases in order to avoid shock to the system. Additionally, governments can focus on structural reforms that promote long-term economic growth, such as investing in education, infrastructure, and technological innovation. By doing so, they can create a more resilient economy that is less reliant on debt and monetary stimulus.

At the same time, it is important to recognise that the post-pandemic world will likely look very different from the pre-pandemic world. The lessons learned during this crisis may lead to lasting changes in how economies operate. Perhaps the most important lesson is that economic recovery is not a simple, linear process. Just as English literature’s heroes and heroines often face difficult trials before they can achieve redemption, so too will economies have to navigate through a series of challenges before they can emerge stronger.

The ongoing debate over central bank stimulus also brings to mind the story of Frankenstein, in which Victor Frankenstein creates a monster that ultimately spirals out of control. Central bank intervention is a powerful tool, but like Frankenstein’s monster, it can be difficult to control once it is unleashed. In this sense, central banks must walk a fine line between providing necessary support for economic recovery and ensuring that their actions do not lead to undesirable long-term consequences.

In conclusion, central bank stimulus measures in the wake of the COVID-19 pandemic have provided much-needed support to the global economy, but they come with significant risks. Inflation, asset bubbles, and unsustainable debt are all potential pitfalls that could hinder long-term recovery. Just as the great literary works caution us about the consequences of unchecked ambition and intervention, central banks must be mindful of the delicate balance they must maintain. The road to recovery may be fraught with peril, but with careful planning and a focus on long-term sustainability, economies can emerge from this crisis stronger than before.