This is the second and final part of my discussion of the – Economic Affairs Commitee (House of Lords) – hearings into – Quantitative Easing: Committee to examine whether inflationary fears justified, the future of QE, and the merits of ‘helicopter money’ approaches. In Part 1 we learned that statements made by notable central bank governors (or equivalent) to the public about what they are doing are highly questionable given the evidence given by two prominent witnesses to the House of Lords enquiry. The evidence doesn’t just refer to matters pertaining to the UK. We learned that it is obvious that large-scale government bond buying programs by central banks are funding fiscal deficits despite the denial from the central bank officials. In this Part, we find more revealing statements by the witnesses further suggest that the central bank officials, including those from the Reserve Bank of Australia governor, are, at best misleading. At worst – use your own words.
We left Part 1 with the conclusion that things at the Committee hearings then got interesting.
Adair Turner, the former head of the British Financial Services Authority, was then asked about “helicopter money”.
Some people using the expression “helicopter money” think that literally it has to mean sending a cheque to every individual, so it is the nearest equivalent of Milton Friedman’s scattering of money from a helicopter and people picking it up and spending it … [alternatively] … should you ever have an element of overt monetary finance? Should you ever run a fiscal deficit? The Government issue debt; the bank buys it and the bank makes it plain that that is permanent and, indeed, that in its purest form it intends in future to finance it with reserves that are not remunerated …
… The benefits of that versus a purely monetary transmission mechanism go back to what I said earlier, which is that when interest rates are already close to zero or lower bound, you are helping to finance a fiscal stimulus that produces a direct stimulus through to the economy where the purely monetary mechanism will not work …
It is because people are worried that there might be constraints on the amount of fiscal deficits that Governments are willing to run, which therefore might leave us in a liquidity trap, that a number of central bankers have argued that under certain circumstances we should have overt money finance …
… you end up, in the case of the Bank of Japan, with no real difference between a permanent commitment to yield curve management at a zero rate and overt monetary finance that is permanent.
I have discussed helicopter money previously:
1. Keep the helicopters on their pads and just spend (December 20, 2012).
2. OMF – paranoia for many but a solution for all – (November 28, 2013).
3. Overt Monetary Financing – again – (November 18, 2015).
6. Helicopter money is a fiscal operation and is not inherently inflationary (September 6, 2016).
In his 1969 book – The Optimum Quantity of Money and Other Essays, Milton Friedman introduced the concept of helicopter money.
In Chapter 1 of that collection, entitled ‘The Optimum Quantity of Money’, Friedman introduces “a highly simplified hypothetical world in which the elementary but central principles of monetary theory stand out in sharp relief.”
His aim is to establish the link between the real quantity of money (“the quantity of goods and services that the nominal quantity of money can purchase”) and the inflation rate.
I won’t go into the detail of this simple economy but for economists it just represents a stripped down Walrasian exchange economy that is in a steady-state – no inflation.
In Section III of this Chapter, entitled “Effect of a Once-and-for-All change in the Nominal Quantity of Money”, he conducted a thought experiement, instigated by the following presumption:
Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.
The question Friedman explores is what would the individuals do with that cash.
Would they “hold on to the extra cash”? If so, then “nothing else would happen”. The only difference would be that the “community’s cash balances” would double (according to his starting assumptions).
Friedman thought that “this is not the way people would behave” and so individuals will increase their spending.
He notes that “one man’s expenditure is another man’s receipt”, which apart from the gender-specific language of the time, is a fundamental principle of macroeconomics.
The point of his exercise is to demonstrate that that a chronic episode of price deflation could be resolved by “dropping money out of a helicopter”.
Once the economy was at full employment, then an on-going helicopter drop would simply drive up prices.
There are many misconceptions about the term ‘helicopter money’.
First, newly printed cash (currency notes) is not typically the way that governments spend. Governments spend by crediting bank accounts (and in some cases sending out cheques to recipients), which then are deposited in bank accounts.
The idea that there there is something different about a helicopter drop (usually characterised as ‘printing money’) and other forms of government spending is misleading and not at all illustrative of what happens in the real world.
Second, from the perspective of Modern Monetary Theory (MMT), a helicopter drop is equivalent to an increase in the fiscal deficit in the sense that new financial assets are created and the net worth of the non-government sector increases.
It occurs when the government uses its currency-issuing capacity (linking treasury spending to central bank operations) to increases its net spending, irrespective of whether the government matches its deficit spending by issuing debt to the non-government sector.
The process is clear – the central bank adds some numbers to the treasury’s bank account to match its spending plans. The Treasury might allocate some government bonds to an equivalent value, which would appear on the central bank’s balance sheet.
So, instead of selling debt to the private sector, the treasury would simply allocate some numbers (debt accounting) the central bank, which had created the new funds that match the new government spending.
This accounting smokescreen is, of course, unnecessary. The central bank doesn’t need the offsetting asset (government debt) given that it creates the currency ‘out of thin air’.
So the swapping of public debt for account credits is just an accounting convention.
To understand the consequences of this policy choice, ask the question, what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) increased its fiscal deficit without issuing the matching $ in debt to the non-government sector?
Crucially, governments spend in the same way irrespective of the monetary operations that might follow. There is no sense to the claim that the government requires currency from taxes or bond sales in order to spend it. The government issues the currency after all.
They can tie themselves up in any number of accounting conventions to hide this reality but the reality is the reality.
Without any matching debt issued to the non-government sector, the treasury would instruct the central bank to credit the reserve accounts held by the relevant commercial banks at the central bank.
The commercial bank’s assets rise and its liabilities also increase because a deposit would be made.
The target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).
Taxation does the opposite.
A fiscal deficit (spending greater than taxation) thus means that reserves increase and private net worth increases.
If there are excess reserves created as a result, then this raises issues for the central bank about its liquidity management.
I discussed these issues in the introductory suite of blog posts:
1. Deficit spending 101 – Part 1 (February 21, 2009).
2. Deficit spending 101 – Part 2 (February 23, 2009)
3. Deficit spending 101 – Part 3 (March 2, 2009).
When the government matches its deficit spending with debt-issuance to the non-government sector it is really only altering the composition of the wealth portfolio of the non-government sector.
This means that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.
The only difference between the Treasury ‘borrowing from the central bank’ and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target.
If private debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the long-time Bank of Japan solution).
There is no difference to the impact of the deficits on net worth in the non-government sector.
This analysis allows us to understanding why it is incorrect to equate helicopter money with quantitative easing.
It is a common misperception to make this association, one that was clearly on display among the Committee Members in the House of Lords.
QE is a monetary operation that is nothing more than the central bank swapping bank reserves (central bank money) with bonds (or other financial assets) held by the non-government sector.
It was introduced on the false premise that banks were not lending because they had insufficient reserves. Cure? Boost their reserves. How? Use central bank money which is in inexhaustible supply to buy bonds held by the banks in return for reserves. QED! Right?
Wrong! As we say in Part 1, it is cler that banks do no need pre-existing reserves in order to make loans.
They worry about whether they have sufficient reserves to cover all the net transactions that are drawn on them each day after the fact and know they can always meet any shortfall by borrowing from the central bank.
The only way QE could boost economic activity is through the lower interest rates it induces in the maturity segments of the bonds the central bank purchases.
Remember, by pushing up the demand for bonds in the secondary bond markets, the central bank drives down yields, which then impacts on related interest rates and might induce higher borrowing.
However, this mechanism is unreliable because if borrowers are pessimistic about the economic conditions they will be reluctant to borrow no matter how cheap the loans might be.
The important point is that QE does not produce any new net financial assets in the non-government sector.
The helicopter option is a fiscal intervention which injects new net financial assets into the non-government sector and directly stimulates aggregate spending.
Back to the House of Lords hearing.
In relation to the helicopter money question, Charles Goodhart, a banking academic and former Bank of England Monetary Policy Committee member, then added:
Under the Biden stimulus programme, every family will be sent a cheque for $1,400. If that is not helicopter money, I do not know what is.
The Fed is now arguing that it will not raise interest rates effectively until it sees inflation occurring. If that is not modern monetary theory, I do not know what is.
We are in a very weird world where we are actually undertaking helicopter money; we are following exactly the precepts of modern monetary theory, otherwise known as the magic money tree; and at the same time we are claiming that we are not doing it. We are doing what we claim we are not doing. I find this situation absolutely weird.
So he gets the point about helicopter money – a cheque being posted to households, immediately increases their holdings of net financial assets, and as Friedman understood, would likely lead to increased spending and increased economic activity (given the recessed state of the US economy).
But, Charles Goodhart’s statement also once again exposed the denial or lying of the central bank officials, which Adair Turner had exposed (see Part 1).
Adair Turner put the icing on the cake:
I absolutely agree with Charles that we are denying things that we are doing. This has become the case in the Bank of England and Federal Reserve, but I have believed for over 10 years that the Bank of Japan is doing permanent monetary finance. There are no believable circumstances in which the Bank of Japan will ever sell back the totality of this massive accumulation of JGBs — over 100% of Japanese GDP. There is none in which it will sell them back …
Although the central bank governor, if you ask him, will always deny that he is doing what Finance Minister Takahashi did in the 1930s, which was overt monetary finance …
… It is undoubtedly true that the Bank of Japan is doing permanent overt monetary finance and post facto we will realise that we have done an element of it here.
How about that? Pure MMT.
I wrote about Takahashi Korekiyo in this blog post – Takahashi Korekiyo was before Keynes and saved Japan from the Great Depression (November 17, 2015).
And then it got even more interesting.
Adair Turner was asked if his contention that “permanent monetary financing” can work, why hasn’t Japan “been a model of economic growth or inflation”?
This is one of the points I often make – that mainstream macroeconomics cannot explain what has been going on in Japan.
Remember all mainstream macroeconomists predicted (and taught their students to predict) that Japan in the 1990s and beyond would have rising interest rates, rising bond yields, accelerating inflation and many went so far as predicting the bond markets would eventually stop buying Japanese government debt.
They try to weave and duck now after their repetitive predictions have repeatedly failed but history tells us otherwise.
Adair Turner’s response was pretty sound:
Japan’s real growth is not all that bad — its real growth per capita compares very well with the G7—but its nominal growth, which is affected by central bank impacts, has been low and its inflation has continued to be below target.
The issue here is, simply: what is the counterfactual? It is my belief that, if you had not had both continuous large fiscal deficits in Japan, which have been running at about 3% or 4% and are now up at 7% or 8% for the past 20 years, financed significantly by central bank money, we would have a still lower inflation rate and, therefore, nominal GDP rate.
So Japan’s real GDP growth rate (that is, its production rate) has been sound but its nominal GDP growth rate has been low because inflation is low.
In other words, if Japan had have followed the advice of the likes of Paul Krugman and his ilk, it would have been in dire circumstances now.
I would also add that unemployment in Japan is typically very low and the fluctuations from the lowest to the highest levels are relatively narrow compared to the swings we witness in other advanced nations.
So when you hear central bankers telling the public that they are not funding government deficits you know otherwise.
That is enough for today!
(c) Copyright 2021 William Mitchell. All Rights Reserved.