By Eric Lonergan
The most direct and efficient solution to the economic and financial problems is for central banks to transfer cash directly to the household sector.Final demand and profits would recover, asset prices would rise and as a result banks would have strengthening balance sheets. Fiscal positions would similarly improve with rising revenue.
These are the effects that policymakers are trying to achieve in an indirect and inefficient manner: we are using governments to do the spending, and we are trying to fix the financial system piecemeal, when the problem is demand, profits and prospective default risk.
Allowing central banks to transfer cash directly to households would be the purest form of Milton Friedman’s “helicopter drop”.
What is lacking is a legal and institutional framework to do this. The helicopter model is right, but we don’t have any helicopters. Open market operations are ineffective at the zero bound because the financial system just holds more cash, as we have seen in Japan. We need to print the money and give it directly to consumers.
Central banks, and not the fiscal authorities, are best placed to make these cash transfers. The government should determine a rule for the transfer. It is the government’s remit to decide if transfers should be equal, or skewed to lower income groups.
This rule should be decided in advance. But the quantity and timing of the transfers should be the authority of the central bank, subject to their discretion and to be used with the intention of meeting their inflation and growth objectives. The central bank would then raise interest rates and shrink its balance sheet when the economy recovers.
The reasons for granting this authority to the central bank are clear: it requires use of the monetary base. Granting government such powers would be vulnerable to political manipulation and misuse. These are the same reasons for giving central banks independent authority over interest rates.
Under the existing legal and institutional framework, the closest equivalent policy to this helicopter drop is for the government to make transfers financed by the central bank. Indeed, I suspect this is indirectly what America will do next year.
Tax rebates (i.e. cash transfers) will likely be a part of Larry Summers and Tim Geithner’s fiscal stimulus and US Federal Reserve chairman Ben Bernanke has already talked – to considerable effect – about buying government debt as a next step for the Fed.
This is an entirely reasonable approach, given current institutional constraints. But a pure helicopter drop has obvious and compelling advantages. It protects central bank independence, and gives central banks a means for stimulating demand quickly and efficiently when interest rates reach zero. What will we do if the fiscal stimulus fails to trigger a recovery?
Possibly of importance is the issue of Ricardian equivalence (the theory that suggests that unfunded tax cuts will have no effect on spending because the public know they will be taxed in future to pay for current government largesse).
Ricardian equivalence is a useful concept not because individuals are hyper-rational, but because the opposite is true: framing matters. If cash transfers are financed by government borrowing from the central bank there will be calls for prospective fiscal policy to be tightened. If the central bank prints money this pressure will not exist, and a framework for responsible use of this tool already exists – medium-term price stability.
We need a legal and administrative framework to allow central banks print money and transfer it to households. This would be efficient, effective and would eliminate the deflation risk for good.
Eric Lonergan is a macro hedge fund manager at M&G Investments