Central Banking’s Final Frontier?

As central bankers worldwide continue to struggle to boost growth, inflation, and unemployment, the real issue is not whether more powerful monetary instruments are still available. The question is whether using them is necessary – or even threatens to do more harm than good.

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LONDON – Have central bankers run out of ammunition in their battle against deflation and unemployment? The answer, many policymakers and economists writing for Project Syndicate agree, is clearly No. “Monetary policymakers have plenty of weapons and an endless supply of ammunition at their disposal,” says Mojmír Hampl, Vice-Governor of the Czech National Bank. The real issue is not whether more powerful monetary instruments are still available, but whether using them is necessary – or even threatens to do more harm than good.

There are, in principle, four broad ways to add more stimulus to the world economy. The obvious course is to keep cutting interest rates, if necessary deeper into negative territory, as suggested by Koichi Hamada, economic adviser to Japanese Prime Minister Shinzo Abe. In Hamada’s view, interest-rate cuts work mainly by weakening currencies and so boosting exports. Likewise, Raghuram Rajan, Governor of the Reserve Bank of India, believes that “exchange rates may be the primary channel of transmission” for monetary easing, but worries that currency depreciation is a zero-sum game for the world as a whole.

A bigger problem is that rate cuts may not weaken currencies at all. As I noted six months ago, the fact is that the “widely assumed correlation between monetary policy and currency values does not stand up to empirical examination.” Indeed, Hamada admits that Japan’s recent rate cuts perversely strengthened the yen: “The effects on the yen and the stock market have been an unpleasant surprise.”

A second option, implemented in March by the European Central Bank and supported by Hans-Helmut Kotz, a former chief economist of the Bundesbank, is to expand so-called quantitative easing (QE). Emulating the approach adopted in 2010 by the US, the ECB is boosting liquidity by purchasing long-term government bonds and other financial assets.

A third standard response is fiscal expansion – cutting taxes and increasing public spending. This is the course recommended by the International Monetary Fund and the OECD. Yale’s Stephen S. Roach, a former chairman of Morgan Stanley Asia, calls over-reliance on monetary policies “a final act of desperation,” one that is “effectively closing off the only realistic escape route from a liquidity trap. Lacking fiscal stimulus, central bankers keep upping the ante by injecting more liquidity into bubble-prone financial markets – failing to recognize that they are doing nothing more than ‘pushing on a string,’ as they did in the 1930s.”

The problem is political, not economic. Fiscal expansion conflicts with what Kotz calls the German “fetish” of balancing budgets “come hell or high water.” The same irrational opposition to fiscal stimulus prevails among American conservatives, who, according to Berkeley economic historian Barry Eichengreen, “have been antagonistic to all exercise of federal government power for the best part of two centuries.”

This leaves the fourth possibility: “Helicopter drops,” the term coined by Milton Friedman for central bankers’ infinite capacity to generate inflation by printing money and distributing it directly to citizens. Rajan describes the idea succinctly: “[T]he central bank prints money and sprays it on the streets to create inflation (more prosaically, it sends a check to every citizen, perhaps more to the poor, who are likelier to spend it).” And today, nearly a half-century after Friedman mooted the possibility of such a policy, there are growing calls to implement it.

The Whir of Helicopters

In principle, helicopter money is equivalent to a universal tax rebate. The crucial difference is that the rebate is not financed by government borrowing in bond markets; instead, the central bank simply emits new banknotes (or electronic deposits).

Kemal Derviş, Vice President of the Brookings Institution and a former Turkish minister of economic affairs, explains why central banks might do better to distribute new money directly to citizens instead of channeling it through bond markets. “[N]ewly created money,” he argues, “would bypass the financial and corporate sectors and go straight to middle- and lower-income consumers. And, “by placing purchasing power in the hands of those who need it most, direct monetary financing…would also help to improve inclusiveness in economies where inequality is rising fast.”

As Michael Heise, chief economist of Germany’s biggest insurance company, Allianz, observes uneasily, Derviş is hardly the only prominent advocate of turning Friedman’s outlandish “thought experiment” into reality: “Proponents of helicopter drops include some eminent figures, such as former US Federal Reserve Chair Ben Bernanke and Adair Turner, former head of the United Kingdom’s Financial Services Authority. And while ECB President Mario Draghi has highlighted obstacles that stand in the way of helicopter drops by his institution, he has not ruled them out.”

In fact, the ECB has gone further. According to Jean Pisani-Ferry, Commissioner-General of France Stratégie, policymakers are “openly pondering” the “right response.” In the event of another recession, he points out, “Peter Praet, the ECB’s chief economist, has explicitly noted that all central banks can [use] the last resort option known as helicopter money.”

But should helicopter money be viewed only as a last resort? Perhaps it is as an immediately desirable policy. Turner, who recently published a book-length prescription for helicopter money, explains why his approach would be much more effective than standard measures like negative interest rates and QE.

Like Derviş, Turner believes that distributing money directly to citizens would avert the financial bubbles created by artificially low interest rates, and that, instead of favoring the rich, who benefit from QE’s financial “wealth effects,” helicopter money would reduce inequality. Even inflationary risks would be diminished, because less money would need to be printed if, rather than relying on the roundabout methods of QE, the economy was stimulated directly.

Unfortunately, as Turner notes, the debate about helicopter money is badly muddled:

“It is often claimed that monetizing fiscal deficits is bound to produce excessive inflation. It is simultaneously argued that monetary financing would not stimulate demand. Both these assertions cannot be true; in reality, neither is. Very small money-financed deficits would produce only a minimal impact on nominal demand: very large ones would produce harmfully high inflation. Somewhere in the middle there is an optimal policy – a common-sense proposition that is often missing from the debate.”

As one of the first economists to advocate helicopter money – or “Quantitative easing for the people” – after the financial crisis, I strongly support Turner’s conclusions. Helicopter drops would not only be more effective than conventional monetary policies; they would also create fewer financial distortions, economic risks, and political protests. Nonetheless, for many observers, the question remains whether the costs of monetary activism outweigh the benefits.

Can Central Banks Be Too Active?

One objection to further monetary stimulus is simply that it is no longer necessary, because economic conditions are returning to normal. Hampl notes that while “central banks are undershooting their inflation targets, that is unpleasant, not disastrous.” Heise argues that “most advanced economies are producing at close to capacity.” In a similar vein, Daniel Gros, Director of the Center for European Policy Studies, points out that “nominal GDP growth far exceeds average long-term interest rates, [implying] that financing conditions are as favorable as they were at the peak of the credit boom in 2007 [and] allowing unemployment to return to pre-crisis lows.”

Of course, not everyone accepts this benign view of global economic conditions. As Nobel laureate Joseph E. Stiglitz has put it: “The underlying problem which has plagued the global economy since the crisis [is] lack of global aggregate demand.” But recognition of the need for more aggressive stimulus policies has not diminished skepticism or downright hostility toward what Nouriel Roubini calls the “conventional unconventional” instruments of QE and negative interest rates that central bankers still officially favor. As Derviş argues:

“Zero or negative real interest rates…undermine the efficient allocation of capital and set the stage for bubbles, busts, and crises. They also contribute to further income concentration at the top by hurting small savers, while creating opportunities for large financial players to benefit from access to savings at negative real cost.”

Instead, Derviş maintains that, “[a]s unorthodox as it may sound, it is likely that the world economy would benefit from somewhat higher interest rates,” though not as “a stand-alone policy.” Instead, “small policy-rate increases must be incorporated into a broader fiscal and distributional strategy” of global policy coordination and probably also helicopter drops.

Another line of attack, especially popular among conservative economists, is that over-active monetary and fiscal policies distract attention from the need for painful measures. Sylvester Eijffinger of Tilburg University in the Netherlands, warns that monetary activism,“by enabling [weaker] economies to borrow cheaply, permits them to avoid implementing difficult structural reforms.” Roubini makes a similar point: While it is true that “monetary policy can play an important role in boosting growth and inflation,” it cannot increase potential growth, for which “structural policies are needed.”

Hans-Werner Sinn spells out this argument sharply: “[T]he more Keynesian and monetarist drugs are administered, the feebler the self-healing power of the markets and the weaker the willingness of policymakers to impose painful detoxification treatments on the economy and populace.” To make matters worse, zero interest rates are encouraging “still-sound economies to become credit junkies. Even Germany, Europe’s largest economy, has been experiencing a massive property boom.”

Turner, the strongest advocate of helicopter money, confronts the issue in disarming fashion: “Some structural reforms such as increasing labor-market flexibility by, say, making it easier to dismiss workers,can have a negative effect on spending.” Is that really what we want? “Vague references to ‘structural reform’ should ideally be banned,” Turner insists, “with everyone forced to specify which particular reforms they are talking about and the timetable for any benefits that are achieved.”

But financial-market participants raise other concerns. According to Alexander Friedman, Group CEO of GAM Holding and former Global Chief Investment Officer for UBS Wealth Management, decision-making by central banks, especially the Fed, increasingly reflects a new implicit mandate to counter global market volatility. “Any suggestion that the Fed will hike faster or sooner than anticipated,” Friedman notes, “leads to fears of tighter financial conditions, and violent risk-off moves.” And yet the perceived need to ensure financial-market stability increasingly conflicts with the Fed’s obligation to set policy in response to domestic economic fundamentals.

As a result, Friedman warns, the Fed’s new mandate “undermines any semblance of central-bank independence,” a concern shared by Howard Davies, the first chairman of the UK’s Financial Services Authority and current Chairman of the Royal Bank of Scotland. The problem, for Davies, is not just that central banks’ policy activism “may be preventing the other adjustments, whether fiscal or structural, that are needed to resolve those impediments to economic recovery.” Central banks are also being assigned a broad range of new tasks: “An institution buying bonds with public money, deciding on the availability of mortgage finance, and winding down banks at great cost to their shareholders demands a different form of political accountability.”

A New Economics in the Making?

How policymakers respond to such conflicting advice will depend on how immovably their countries are trapped in economic stagnation. In the US and Britain, conventional QE and zero interest rates have broadly restored full employment, if not yet adequate growth. So pressure for radical measures is likely to remain subdued – at least until the next recession. In Europe and Japan – and possibly in China – the arguments for uniting monetary policy, fiscal stimulus, and income redistribution through helicopter money are more compelling.

Sending free money to all citizens from central banks may sound bizarre, but sooner or later public patience with economic stagnation may be exhausted – and radical action may become politically irresistible. As Harvard’s Dani Rodrik observes: “The only surprising thing about the populist backlash that has overwhelmed the politics of many advanced democracies is that it has taken so long.” After all, “the first era of globalization, which reached its peak in the decades before World War I, eventually produced an even more severe political backlash.” The result was the transformation of “[Adam] Smith’s minimal capitalism…into Keynes’ mixed economy.” As that example shows, “capitalism’s saving grace is that it is almost infinitely malleable.”

Likewise, I recently suggested that what lies ahead is a reinvention of policies and institutions no less radical than the transformations of the 1860s, 1930s, and 1980s. Rodrik does not treat the Thatcher-Reagan revolution of the 1980s as the start of a distinct phase. But our arguments are essentially similar. One way or another, global capitalism, along with the monetary, fiscal, and distributional policies that sustain it, will need to be reconstructed. Today’s increasingly heterodox monetary policies should be viewed as the start of this process.