Commentary | 29 February 2016

No way out for global economic policy?

Originally published in the Nikkei Asian Review.

Originally published in the Nikkei Asian Review.

Executive Summary

The weekend meeting of the G20 economic ministers in Shanghai on Feb. 26-27 produced the predictable rationalizations for doing nothing to address the world's still lackluster recovery from the 2008 financial crisis. Everyone points to structural reform as the panacea, but no one has yet answered the lament of European Commission President Jean-Claude Juncker who once said: "We know what to do; we just don't know how to get re-elected after we have done it."

Behind the inevitable platitudes of the communique - which broadly flagged the risks to global growth but failed to agree on any concrete action to tackle the problems -- is an implicit message that macroeconomic policies have run out of effective instruments. With increased fiscal spending off-bounds due to debt concerns, that inconclusive message follows efforts by some G20 members - particularly Japan -- to explore various versions of unconventional monetary policy.

Despite the daily dose of disaster scenarios from the financial media and market commentators, the current situation is much the same as it has been for the past four years, with global annual growth hovering around 3%. Nevertheless just about every country would like to be growing a bit faster. Some argue that the problem is structural and is either largely unavoidable because of aging demographics, for example, or requires far-reaching reforms that politicians find hard to launch.

Others, such as Paul Krugman, argue that whatever the failings on the supply side (every country has untapped potential for structural reform), there is also deficient demand. Most countries applied coordinated fiscal stimuli in 2009 that successfully boosted global growth in 2010, but then everyone started worrying about government debt levels. As a result, the crisis-affected economies strongly constricted fiscal spending. Meanwhile, borrowers in the private sector shared these debt concerns. In the new mood of austerity, they felt overcommitted and reined in expenditure to repair their balance sheets. How could a strong recovery take place in these circumstances?

Monetary policy was left as the only operational arm of macro policy. The conventional monetary instrument - the short-term interest rate - dropped to near-zero: a most unusual setting. With this stance, monetary policy is still strongly stimulatory: it is like putting the car accelerator to the floor - its effect continues even if it is not pushed any further.

Even so, this has not been enough to halt the turmoil, hence the resort to "unconventional monetary policy". The first element was quantitative easing. Most commentators judge that it has had some effect, but again it has fallen short.

The second element - negative interest rates - is being explored by five countries, most recently by Japan in late January. The sky since then has not fallen in, despite dire warnings by some critics. Depositors have not - as some feared -- withdrawn their bank deposits and fled to cash holdings. But that is because policymakers have not gone far into negative territory, and hence banks have not tried to pass on the negative rates to depositors. Policymakers now feel constrained by the possible damage that bolder moves into negative territory might do to bank balance sheets and profits.

As a result, there is now increasing talk of "helicopter money" - the most unconventional policy of all. Under this concept, central banks would give away cash to households. This was first proposed by Milton Friedman and subsequently explored in a speech by Ben Bernanke in 2002, when he was already a U.S. Federal Reserve board member but not yet Fed chairman. The image of the helicopter dropping banknotes is compelling, but it would not happen so dramatically or so randomly. Many Australians will remember the "cash splash" of 2009, when most families received a direct deposit from the government into their bank accounts. It is usually judged to have been successful in providing a boost to demand. This was similar to, but not the same as, a helicopter drop as envisaged by Friedman and Bernanke. The important difference is not in the method of delivery, but in the method of funding. This expenditure was funded from the budget, notdirectly from the balance sheet of the central bank. This was unambiguously fiscal policy, not monetary policy.

The "helicopter money" myth

The Friedman/Bernanke helicopter money proposal is misguided, both "in principle" and for technical reasons. There is a long history (most famously in the adventures of 18th century financier John Law) of governments using the funding capabilities of their central banks to finance profligate expenditure, such as foreign wars. Industrialized economies have not experienced a repeat of this sort of central bank funding of budget deficits since the Weimar Republic, but it is still essential to good governance that the budget is subject to a democratic process where lawmakers have the opportunity to peruse expenditure plans and at the same time are disciplined by the need to sell government bonds to finance a deficit, rather than lean on the central bank.

Central banks have been given a high degree of independence, but only within a well-specified policy framework (often inflation targeting), surrounded by accountability and transparency requirements. Even when central banks implemented QE, they were not "printing money" and giving it away; they were buying government bonds in exchange for central bank money, usually in the form of a deposit at the central bank. They have not, anywhere, been given a mandate to override the budgetary process and give away cash or, for that matter, make any other form of expenditure. Central bankers may think that more fiscal stimulus would be appropriate and they might argue behind the scenes for this, but they have no remit to make expenditure themselves, funded from their balance sheet.

There are also technical issues that create analytical misunderstandings that make helicopter money sound more attractive than it would be in practice. Helicopter drops are proposed because the budget has run into some kind of debt constraint that prevents it from funding the stimulatory expenditure (say, a cash splash or extra infrastructure) by issuing more government debt in the usual way. But helicopter drops create central bank money ("base money"). When this is distributed, the public might keep part of this in the form of currency - the paper notes in wallets and purses. The rest, as a residual, is deposited in the commercial banks.

But under current circumstances, the banks do not want to expand their balance sheets through increased lending, so they would place it on deposit back at the central bank. The final effect is that the central bank now has more debt on its balance sheet in the form of these deposits, on which most central banks pay a market interest rate. Combining the debt - and debt servicing - of the budget and central bank would be the same as if the expenditure had been made from the budget, funded by the issuance of government debt.

It is hard to see this idea as anything other than an attempt to trick the public and the credit rating agencies into thinking that helicopter drops do not raise official debt. It might even succeed in this: the public has other things to think about and the credit rating agencies gave a clear demonstration of their self-interested incompetence in their readiness to hand out AAA ratings in the years leading up to the 2008 financial crisis.

If fiscal policy is being hamstrung for the wrong reasons, it could even be argued that the helicopter drop is the only available solution, even if it is second best. This was the argument of Adair Turner, the former chairman of the U.K. Financial Services Authority, at a recent International Monetary Fund research conference.

The better policy, by far, is to make the case within the conventional budget governance framework that extra fiscal expenditure is well justified. Milton Friedman's key message was not about helicopter drops, but was to remind people that in economics "there is no free lunch." Any G20 economic minister secretly attracted to this idea would do well to reconsider and instead explore the opportunities for conventional fiscal stimulus, as advocated by the International Monetary Fund in Shanghai.