The Room151 Long Read: James Bevan on central banks and helicopter money

Central banks seem to be running out of options with commentators suggesting increasingly novel methods to stimulate economic growth. James Bevan considers helicopter money, abolishing cash, bond defaults and collapsing bond yields as possible cures for the current malaise.

The life blood of long-term investment programmes (seeking to make sustainable real distributions of around 4% without impairing the long term inflation-adjusted value of the capital) is decent real economic growth. Hence it is important that we focus on the risk of secular stagnation – which increases if policy decisions are poor.

There are already signs of a slowing of productivity growth and growth in value added, which we can trace to three or four key factors.

First, there has simply been ‘bad luck’ in that much of the technological change that we have witnessed over the last fifteen or twenty years has tended to be deflationary for median incomes.

Thus, for example, e-bay, Amazon and uber have damaged the incomes of competitors and inflated the incomes of the proprietors, which delivering reduced costs for consumers.

This type of technologic induced slowdown in overall growth occurs from time-to-time and can enhance overall standards of living even if recorded growth is poor. What’s more, there is probably little that the world can do about it other than to accept it and adapt, evolving a new economic eco-system.

Secondly, and despite the marketing-driven rejoicing in the concepts of the BRICs and other emerging market groupings, higher incomes have generally not been achieved in developing economies.

Thirdly, it is arguable that there has been too much focus on the ‘wrong sort’ of economic policy making, exemplified by the Euroland fixation with currency union rather than underlying growth and structural reform.

The result has been a relative lack of entrepreneurism and dynamism, and this can be observed in many economies where regulations in pursuit of ‘less risk’ have cost free spirit and arguably led to more risk being experienced at a whole economy level.

Finally, we may suspect that the biggest single contributor to weak productivity growth in recent years has been the rise of non-traded goods prices relative to traded goods prices, with the increase in non-traded goods prices implicitly biasing economic development in developed markets into the lower productivity growth generating service sectors and away from the higher productivity growth traded goods sectors.

On this basis, much of the slowdown in trend productivity growth has come from a simple shift in the composition of the economies.

Efficient pricing

The cause of the rise in the prices of non-traded goods, relative to traded goods prices, has been the emergence of North Asian (excess) capacity and the response of developed markets to the challenge.

This may seem contrary to received wisdom, if not heretical, but it does seem that much of North Asia does not seek to price its traded goods, and in particular its exports, efficiently.

Instead, these countries seem to use overt and implicit subsidies to price below ‘normal cost’. Whilst they may cover their variable costs of production, they either do not cover their fixed costs or, crucially, make what can be called ‘normal profit’.

Hence, the region’s various competitors have found themselves facing traded goods prices with which they cannot compete and their growth has therefore been obliged to come from their low productivity growth non-traded goods sectors.

Asia’s bias towards the over-production and deflationary production of traded goods has in this way obliged developed markets to become over-reliant on causing inflation in its non-traded goods sectors, and in order to foster growth in its non-traded goods sectors, developed markets have been obliged to rely on exceptionally easy monetary policies to support booms in house prices, in commercial property construction and in hospitality-type functions.

Finding a cure

In terms of possible cures to the malaise, developed markets need to focus on anything that lifts its rates of productivity growth, such as investment in education and the elimination of bureaucracy.

Apart from reform of Euroland, developed markets should also consider just how they can help the developing world raise its incomes and levels of demand on a sustainable basis. When all is said and done, BRIC-style capital flows booms are not a form of sustainable development policy, even if they make their instigators huge sums of personal wealth.

More contentiously, we can argue that developed markets should move to encourage North Asia to reform as quickly as possible, so that Asia prices its goods more efficiently in an economic sense, or developed markets should impose appropriate levels of tariffs on Asia’s sub-optimally priced goods.

The only problem with the latter would be that if developed markets were now to engineer a rise in traded goods prices, then the impact on headline inflation rates and hence bond prices might well be most unwelcome but that would be the ultimate cost of developed markets’ own recent over-use of monetary policy in an effort to try to hide the types of fundamental problems described above.

At the end of the day, monetary policy can only be used to steal demand from other people (i.e. a competitive devaluation) or to borrow it from the future for a period of time (by temporarily depressing savings rates) – but over the long term, the level of GDP is defined by the number of people working multiplied by their average productivity, and the amount of money in circulation is unlikely to affect either of those variables.

Unfortunately, developed market politicians seem unwilling or unable to grapple with the fundamental issues and instead seem determined to continue to oblige their central bankers to come up with yet more monetary expansion.

helicopters  and ‘ truer form of QE’

So-called ‘helicopter money’ is mooted as a possible way forward by those that still believe that monetary policy can offer an answer to the world’s sluggish economy.

‘Quantitative Easing’ programmes were designed to allow central banks to push bond yields lower so that potentially the demand for credit might rise and there would be a price-driven portfolio rebalancing effect that would encourage either companies (through lower corporate bond yields) or households (through higher asset prices) to spend more.

Thus in reality, QE was never really about quantities but actually about (asset) prices and yields. However, with negative interest rates now seen by many as impoverishing and constraining key financial institutions, and causing savings rates to rise rather than fall, some are beginning to suggest that central bankers should embrace what they see as a truer form of QE – namely, asking central banks to simply credit every bank account with some quantity of new money with the hope that this type of direct action should get people to spend more. This is the concept behind so-called helicopter money.

The problem with helicopter money is that by giving people physical cash, or by crediting people’s bank accounts and then accepting the resulting and necessary rise in commercial banks’ holdings of reserve deposits, the central bank will by definition occasion an increase in its own stock of monetary liabilities.

However, the central bank will not at the same time achieve an increase in its assets – and if the central banks’ assets don’t rise but their monetary liabilities do, following a helicopter operation, then by implication their stock of non-monetary liabilities would actually have to fall.

In practice, the only non-monetary liability of a central bank is its own capital (either equity or debt-financed) and it follows that if central banks adopt helicopter money-type policies, then they would have to destroy their own capital bases many times over, and likely become hugely negative capital institutions.

With some central banks such as the Bank of Japan (BoJ), we can doubt that they can in fact vote to operate with negative capital given that they are listed companies with private sector shareholders.

Meanwhile with Europe, we may suspect that many of the national government sponsors would naturally baulk at the notion of the European Central Bank (ECB) running with negative capital, and therefore becoming yet another potentially significant contingent liability for their public sector accounts.

Negative capital precedents

We do have some precedent of history for when central banks have operated with either deficient or negative capital, such as the Bank of Korea in 1988-89 and Bank Negara Malaysia following its ill-advised currency speculation in 1992. These banks have usually been swiftly recapitalized by their respective finance ministries at the cost of an increase in government indebtedness (albeit using bonds sold to the central bank).

But the point is that this route simply takes us back to the current conventional form of QE and this is where direct fiscal policy comes into consideration. It would be simpler, and more honest for governments, simply to give people tax refunds and cover the resulting (wider) fiscal deficits through bond sales to commercial banks and other investors.

There are those that argue that fiscal policy is already too lax and any further expansion would be very dangerous, but if a central bank ran with negative capital, any suspicion that it faced difficult conditions could lead to a run on a currency by investors seeking to avoid exposure to a failing central bank, then leading to either deep deflation or hyper-inflation.

In addition if concerns about a central bank’s positon led to a decline in internal demand for the home currency money, as would be quite likely, then we might see buying of assets as a store of value, risking an acceleration of inflation of property and perhaps even goods prices.

Of course, the action of people in effect ‘dumping’ cash might cause economic activity to pick up in the short term, but once this activity turned into inflation, the central bank would find itself scrambling into reverse as savers took fright.

Were there to be a lurch from gentle deflation towards relatively high inflation in Euroland, this would surely kill the project once and for all. More broadly, we may suspect that it was these issues and the calamitous currency falls experienced, that led Korea, Malaysia and others not to allow their central banks to operate without adequate capital.

In short, while conventional QE in recent years has not in general created much in the way of real-world money outside the banks, and even less monetary velocity, helicopter money even (if it could be orchestrated from an accounting sense) could well create not just a great deal more ‘money’ in the hands of people but also a lot more velocity – and the impact of central banks with negative capital and helicopter money are immensely hard to predict, and are potentially quite dangerous.

But the killer blow is that in any case helicopter money would be most unlikely to solve the fundamental problems facing economies.

Abolish cash

One other strategy that has been suggested is that the central banks should abolish cash so that people cannot flee into physical cash in order to escape would could then become ever more negative rates and yields.

Besides the fact that this would be tricky in a democracy because such a move would represent immense financial repression, and voters would punish the incumbent governments at the first available opportunity, the impact on the pension and other long term savings institutions of ever more negative rates and yields would likely be catastrophic. The latter could then be expected to lead to a further counterproductive rise in savings rates, as already witnessed in Europe.  Fortunately, abolishing cash is neither practical nor desirable.

More broadly, negative bond yields may be a bad idea regardless of whether cash can be abolished or not. Once yields turn negative the only real reason to hold a bond would seem to be the hope of obtaining a holding gain, indicating that bond ownership only makes sense if deflation is accelerating and central banks are also committed to almost limitless QE at ever higher prices.

This dynamic is of course useful for central banks when bond prices are on the way up but it would no doubt be disastrous if there were to be an adverse inflation surprise – and a poor higher-than-expected inflation number could result in a massive, vicious and destabilizing reversal in bond prices as the ‘entire’ market attempted to unwind positions.

Moreover, whilst yields are negative, insurance companies find themselves praying that equity markets only ever rise (so that they will be able to settle claims), and the tendency towards an overvaluation of property (and hence non-traded goods prices which tend to be highly correlated with prevailing property prices) will be exaggerated even further, with all that this would then imply for home ownership, income & wealth equality, and of course long term productivity growth.

So, the idea of abolishing cash in order to make negative yields somehow sustainable – even in a world or contactless payments and Google-Pay – would represent a form of utter madness that thankfully is probably politically impossible.

Bond defaults

Another scheme that appears surprisingly popular at present is the notion that central banks should allow their respective governments to default on the bonds that they own within their domestic securities portfolios. The rationale offered in support of this idea is that since governments own (most of) the central banks, and the governments owe the debt, this debt can simply be cancelled.

Unfortunately, there is a balance sheet problem. The central banks’ holdings of bonds (both domestic & foreign) represent the asset on their balance sheets that is used to match their monetary liabilities.

Therefore, assuming that the central banks are not in fact prepared to run with negative capital following what would amount to a very significant write down of their assets, then if the banks were to write down the value of their bond holdings, they would also have to cancel a significant proportion of the reserve deposits of the commercial banks (i.e. the central banks’ monetary liabilities).

At this point, the commercial banks would either then be obliged to suffer a debilitating loss of their own capital as they realized losses on their reserves, or they would have to impose a haircut on the assets of their depositors.

Neither action would likely be good news for the economy, and a banking crisis would be virtually assured under this scenario. In short, bond defaults are rarely good news for savers or the underlying economies.

Temporary collapse

Perhaps a rather better and certainly more practical version of the ‘cancelling government bonds’ scheme, and one that we may suspect is about to be enacted in Japan, would be for the central banks to temporary collapse bond yields to zero or below across the whole length of the yield curve and to then consolidate a significant proportion of the central banks’ bond holdings into one giant perpetual zero coupon bond.

From the point of view of the cash flow of the finance ministries and the public sector’s own budget statements, this action would have the advantages that would be associated with cancelling the existing debt, but it would not lead to the types of balance sheet problems described above.

To be clear, this type of ‘accounting scam’ would involve more unhelpful financial repression, it would do little or nothing to solve the structural problems that economies face, and it would leave an economy’s monetary system backed not by ‘productive assets’ such as loans to real companies but instead by unproductive zero-yielding government bonds.

But it would nevertheless represent a neat solution for governments that have in effect ‘given up’ on growth. In Japan’s case, given its weak demographics, the scheme would not be without merit – even if structural reform, the third arrow of Abenomics, would still have been a better option.

Our conclusions?

In reality, the various suggestions for new forms of monetary madness that are currently doing the rounds in the press and elsewhere probably have little to commend them from the point of view of stimulating long-term growth, and many of them could have acutely adverse side-effects that would be dangerous and difficult to control.

That said, the idea of a conversion of existing central bank holdings of government bonds into a zero coupon perpetual bond does have some merit within the context of static or shrinking economies such as Japan, but even this would seem to represent an admission of failure rather than a proactive and positive policy response.

So, it would seem that if policymakers really are not prepared to enact the types of deep-seated structural reforms that can lead to faster real sustainable growth, and are instead set on creating another temporary ‘demand side stimulus’, the best we can hope for is another episode of monetized financing of expanded fiscal deficits, as was undertaken with some limited success during 2009-10.

Of course, even this type of policy would risk leaving the relevant governments in weakened financial positions themselves. If you’re interested in what might be going on and haven’t studied economics, google ‘Ricardian equivalence’. Even if you’re not interested in that, it’s a matter of fact that even the immense efforts of 2009-10 only yielded modest temporary results.

For those seeking a quick temporary fix to the problem of weak world growth, easier fiscal regimes that are financed by the banking systems (most likely the central banks) are probably the only viable options at present.

Despite its apparent attractiveness, helicopter money is not a viable option.

If that wasn’t enough here are examples of the literature on ‘Helicopter Money’

Helicopter money (Simon Wren-Lewis, Oxford University): Professor Wren-Lewis provides an introductory guide to the concept of “helicopter money”. The author points out that helicopter money is really a form of fiscal stimulus. The original Friedman metaphor involved the central bank distributing cash by helicopter, but the real-world equivalent would be a tax cut of some form. “Helicopter” money differs from a conventional tax cut in that it is paid for by the central bank printing money, rather than the government issuing debt.

The case for monetary finance – an essentially political issue  (Adair Turner, Institute for New Economic Thinking): In this paper Adair Turner assesses the possible role for monetary finance of fiscal deficits – “helicopter money”. He argues that the important issues are political, since the technical issues are well understood and its desirability in some circumstances is clear. In his view, monetary finance of the fiscal deficit will always raise aggregate nominal demand; in some circumstances it will also be preferable to all other policy tools; and there “is no knife edge nonlinearity which makes dangerously high inflation inevitable”.

The simple analytics of helicopter money: why it works – always (Willem Buiter): Willem Buiter provides a technical analysis of Milton Friedman’s parable of the “helicopter” drop of money. He derives three conditions that must be satisfied for helicopter money to always boost aggregate demand. “First there must be benefits from holding fiat base money other than its pecuniary rate of return. Second, fiat base money is irredeemable – viewed as an asset by the holder but not as a liability by the issuer. Third, the price of money is positive.” Given these three conditions, there is always a combined monetary and fiscal policy action that boosts private demand – “in principle without limit. Deflation, ‘lowflation’ and secular stagnation are therefore unnecessary. They are policy choices.”

“Helicopter money” won’t provide much extra lift (Narayana Kocherlakota, University of Rochester): Ex-President of the Minneapolis Fed, Narayana Kocherlakota, argues that the excitement surrounding helicopter money is unwarranted and misses an important point: “the government has all the borrowing and spending power it needs to boost the economy and get inflation up to the desired level, if only it had the will”.

Helicopter drops reloaded (Huettl & Leandro, Bruegel): In article 2. above, Adair Turner argues that helicopter money is both technically feasible and desirable. Here, Huettl & Leandro argue that there is no doubt that helicopter money will stimulate aggregate nominal demand, and in some circumstances it is even a better and less risky tool than any of the available alternatives. These alternative options include negative interest rates, debt-financed fiscal deficits, and quantitative easing.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

*CCLA is a supporter of Room151

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