Mervyn King said
“Central banks are often accused of being obsessed with inflation.
This is untrue. If they are obsessed with anything, it is with fiscal
policy.”
As an academic turned central banker, King knew of what he spoke. The
fear is sometimes called fiscal dominance: that they will be forced
to monetise government debt in such a way that means inflation rises
out of control.
I believe this fear is a key factor behind central banks’
reluctance to think seriously about helicopter money. Creating money
is no longer a taboo: with Quantitative Easing huge amounts of money
have been created. But this money has bought financial assets, which
can subsequently be sold to mop up the money that has been created.
Under helicopter money the central bank creates money to give it
away. If that money needs to be mopped up after a recession is over
in order to control inflation, the central bank might run out of
assets to do so. A good name for this is ‘policy insolvency’. [1]
There is a simple way to deal with this problem. [2] The government
commits to always providing the central bank with the assets they
need to control inflation. If, after some doses of helicopter money,
the central bank needs and gets refinanced in this way, then
helicopter money becomes like a form of bond financed fiscal
stimulus, but where the bond finance is delayed. In my view that
delay may be crucial in overcoming the deficit fetishism that has
proved so politically successful over the last five years, as well as
giving central banks a much more effective unconventional monetary
instrument than QE. [3] But central banks do not want to go there,
partly because they worry about the possibility of a government that
would renege on that commitment.
The fear is irrational for two reasons. First, central banks already
face the possibility that they may make sufficient losses on QE that
they may require refinancing by the government. The Bank of England
has requested and been given a commitment to cover those losses.
There is no conceptual difference between this and underwriting a
helicopter drop except probabilities.
The second reason is more basic. In today’s world, where in the
major economies it is now well understood that interest rates need to
rise in a boom to control inflation, it is hard to imagine a
government that would make its central bank impotent by refusing to
provide it with assets. If such a government ever existed, it would
have long before ended central bank independence because it wanted to
stop it increasing interest rates with the assets it already had.
Under the government of central bank nightmares, the central bank
would lose its independence before it could complain that the
government was reneging on an earlier commitment to underwrite
helicopter money.
The fear of fiscal dominance is itself not irrational, although it
seems increasingly unlikely it would happen in a modern democracy.
What is irrational is thinking that allowing helicopter money in a
recession would make fiscal dominance more likely to happen. [4]
I have also argued that this irrational fear has already been costly.
I have described
how the widespread adoption of austerity at the beginning of the
recovery represents the failure to politicians to follow basic macro.
Here central banks become a policy intermediary between academia and
politicians: they have the knowledge of how costly austerity can be
when rates are zero. But what politicians heard from senior central
bankers was not these costs, but encouragement to pursue austerity.
An irrational fear of budget deficits may be one explanation for
central banks being economical with the truth.
Central banks overcame one big psychological barrier when they
undertook Quantitative Easing. That was the first, and perhaps the
more important, stage in ending their primitive fear of fiscal
dominance. They now need to complete the process, so we can start
having rational discussions about alternatives to QE.
[1] A central bank cannot actually become insolvent, as this post
explains.
[2] No one to my knowledge has ever proposed giving the central bank
the legal power to collect a poll tax.
[3] A key feature of deficit fetishism is a concern about deficits in
the short term. Politicians seem happy to take measures that cut
deficits in the short term even if debt becomes higher in the longer
term. Indeed the analysis presented
by DeLong and Summers argues that hysteresis forces would not have to
be that large before austerity would raise long run debt to GDP
levels. We also know that deficit fetishism is specific to increases
in debt caused by recessions: over the longer run if anything deficit
bias implies rising rather than falling levels of government debt. So
any form of fiscal stimulus that avoided an increase in debt in the
short run but not in the long run would avoid deficit fetishism. That
is what a money financed fiscal stimulus aka helicopter money aka
People’s QE could do.
[4] Why am I confident that a government could not be so obsessed
with its debt that it might renege on an underwriting pledge? It is
because deficit fetishism is only politically attractive in a
recession when individuals are themselves cutting back on their
borrowing, and therefore feel the government should do the same. This
will not apply when the recovery has taken place and inflation is in
danger of exceeding its target.
