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Much of the Western world remains trapped in sub-par economic performance at best, or 1930s style depression at worst. The Pavlov reaction was to drive monetary policy into overdrive, and slash rates to zero. This has worked in the ordinary world of garden variety business cycle recessions that are caused by the economy overheating, and then the Fed slamming on the brakes.

But these are no ordinary times. In the famous words of Richard Koo from Nomura:

"If central banks bring interest rates down to almost zero and nothing happens then it is not an ordinary world."

Indeed it isn't, as Koo has explained tirelessly, this is a recession caused by the private sector recovering from a private debt overhang, resulting from the implosion of an asset bubble, slashing debt in order to repair balance sheets. When the private sector is cutting down borrowing and spending and preferring to pay down debt even at zero interest rates. the correct policy response is for the public sector to step in.

But despite the fact that this is exactly what has kept Japan, suffering from a much larger asset bubble implosion in the early 1990s, afloat, this is somehow not politically feasible in most countries.


This isn't likely to change anytime soon, even now that the IMF has shown that fiscal policy is a much more potent policy instrument under these circumstances than previously thought.

Instead, we have the distinctly ersatz policy named QE, that is, quantitative easing, in which central banks buy longer date financial paper from the private sector in order to stimulate economic activity, mostly through lowering long-term interest rates. While the numbers are large (the Bank of England has amassed some 25% of GDP's worth of longer term public debt under QE, for the FED this is closer to 10%), the effectiveness is rather questionable.

While the fears of accelerating inflation haven't materialized even in the British case (quite the contrary, in fact), it is also difficult to argue that QE has been a rousing success. For the likes of Koo this isn't a surprise. He argues that when the private sector is paying down debt no matter what, monetary policy is impotent.

Helicopters to the rescue?
But here is where another idea comes in, an idea that has lineage from two of the greatest economists of the 20th century, John Maynard Keynes and Milton Friedman. Keynes raised the idea of putting bottles filled with money in the ground and let the private sector dig them up. Friedman went a step further, suggesting money dropping from helicopters in the sky.

While Keynes idea still is closer to fiscal policy (public works), Friedman is monetarist in essence. On a certain level, it's really not that different from the normal tools available to central banks. These tools, like interest rate setting, are used to create a certain level of demand, keeping the latter close to potential supply while avoiding exceeding it which is likely to stoke inflation.

These policies mainly work through credit creation. When banks provide credit, they create money, as they credit your account with money that didn't exist before. Prudence (or law in certain countries) obliges them to keep a fraction of reserves against the newly created credit (money), which is one point of leverage central banks have over this process.

But what if, despite all efforts of central banks by lowering interest rates and ensuring the commercial banks have plenty of reserves, the private sector simply isn't interested in more credit. This situation is the famous Keynesian 'liquidity trap' in which central banks are pushing on a string. They're stuffing banks with more reserves, without this having much, if any, noticeable effect on credit (and hence money) creation which is supposed to drive economic activity higher.

This situation is exactly what happens when the private sector, rather than taking on new loans, wants paying off old debt. This usually happens when their balance sheets are significantly worsened by some financial shock. This is what happened in the 1930s, it's what happened to Japan in the 1990s, and it is what happened in the US in 2008, when the financial crisis and the aftermath wiped off 40% (or a whopping $9 trillion) of balance sheets of households due to the fall in house prices.

The Fed can't lower interest rates (those that are under it's direct control) anymore, these are essentially zero. And this hasn't had much of an effect on lending. It has literally stuffed banks with excess reserves.

What it (and other central banks) has tried is to lower longer term rates that are not under direct control via quantitative easing (QE), buying longer dated securities like government bonds. While mildly helpful at best, QE is needlessly laborious in its transmission mechanism and the effects are likely to remain largely in the financial sector.

In the meanwhile, demand, while recovering, is still running significantly below production capacity. The longer this continues, the more damage will be done to the production capacity itself. Lack of investment slowly obsoletes plants and long-term unemployed become demoralized, lose skills, and are discriminated against when hiring finally picks up.

So if monetary policy is simply demand management, with the aim of keeping demand close to production capacity, why not execute it in a more direct way, which is where Friedman's helicopter money comes in. The Fed could write every US citizen a cheque (or perhaps target it in some way by means testing).

This would simply amount to a tax cut, but one without the Government having to borrow for it. Instead of working via the credit creation by inducing people to borrow more, people would simply get the money. Would it work? Well, households will either save or spend the money, and either way, this would accelerate the recovery.

Money saved would speed up the deleveraging process, households paying down existing debt and repairing their balance sheet. Spending will have a more direct effect, and stimulate economic activity which can kick-start the economy.

One could (and many will) argue that the big fear would be to trigger inflation. But that would be a byproduct of a more robust recovery, which would, in no doubt, induce central banks to raise interest rates to more normal levels and consider helicopter money a one-off.

There are other, more political advantages. We know that during the rebuilding of balance sheets in the aftermath of a financial crisis, fiscal policy is especially potent, while monetary policy loses much of its traction, because the latter works through the credit creation process while people want to repay debt, not take on more, no matter how low interest rates are.

But fiscal policy has run into political and ideological problems while public debt cannot be accumulated forever. Helicopter money would bypass some of these problems. It doesn't require either the public or the private sector to take on new debt. Moreover, those objecting to increased public spending might be less inclined to object as helicopter money depends on increased private spending.

We happen to think that the latter is somewhat unfortunate, as there are public spending possibilities (education, infrastructure, research) that not only increase demand now, but have lasting effects improving the supply side of the economy, and a slump in which interest rates are low and fiscal policy potent is exactly the right circumstance to embark on such a program. But we are aware of the largely ideologically driven objections, so this would bypass these.

Another problem is that this idea, even if it comes from Milton Friedman, is so far out that any central bank implementing it stand to risk losing a great deal of credibility. Friedman certainly meant for conditions of deep economic depression only, like the 1930s. With the American economy coasting at 2% growth, this is pretty far from what Friedman had in mind.

But, if much of monetary policy is simply demand management and the nature of the present crisis has made existing monetary policy instruments rather ineffective, it could, and perhaps should be considered as simply a more effective tool to achieve these aims and judged on the balance of the advantages and disadvantages.

On balance we would still prefer other solutions. As explained above, increasing public investment in education, research and infrastructure not only provides the same or better immediate boost to demand, it has the additional benefit of improving the supply side.

The disadvantage is that it adds to public debt, but with interest rates low it should be considered as any investment. As long as the expected returns are better than the cost of capital, projects should go ahead.

We still have every reason to think that rising inequality has been the ultimate cause behind insufficient demand. From the mid 1970s, median wages started to lag labor productivity, and that gap has continued to increase.

(click to enlarge)

This simply means that wage earners are increasingly unable to buy an ever larger part of what they produce.

This lack of demand has been masked by reduced saving and increased borrowing, in the latter stages on the backed by rising house prices. But then the house bubble burst and now the government had to step in to fill the large demand gap that was the result of that. But the fundamental problem, rising inequality, hasn't been addressed at all..

Source: Helicopter Money, The Logical Conclusion Of Demand Management?