Monday, December 8, 2008

Central banks need a helicopter

--helicopter dropping model might be warranted to distribute cash to the hands of consumer if banks still conserve cash --printing money is different from borrowing money from consumers through notes --this method might work when interest rate drops to zero 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 December 4th, 2008 in Central bank independence, Central banks, Global economic crisis, Government spending | Permalink 5 Responses to “Central banks need a helicopter” Comments Alistair Milne: I wish what Eric writes were correct, that the entire crisis can be solved by the central bank distributing cash to households and getting them to spend again. But I regret to say it is pipedream to think that the central bank can do this without an accompanying fiscal expansion. Take the simplest possible version of this policy - printing billions of notes and using secure mail to send them to citizens. The central bank can do this, but by giving the notes away for free, it undermines its own balance sheet and then itself becomes insolvent. An insolvent central bank is hardly a recipe for promoting financial stability. You might think that the central bank will survive, since there is no interest payment on notes, there is no cash flow cost, only printing costs. But most notes will end up placed in bank accounts, increasing bank reserves with the central bank on which interest is paid. So the central bank will experience massive loss of interest revenue. The same problem applies if the central bank creates reserves and uses them for credit transfers to households - if done on a large scale without an accompanying fiscal expansion the central bank balance sheet is undermined. The only way to implement this policy without undermining the central bank balance sheet is for government to borrow the money that is transferred to households through a bond issue (The easiest course of action is simply sell these bonds to the central bank, exchanging them for an increase in government accounts with the central bank, and the necessary credit transfers to citizens can be made using this government money, in an environment of collapsing credit this monetization is not inflationary). The bottom line is that what Eric has in mind is simply a fiscal stimulus of the kind already tried in the US and now being attempted in other countries as well. Whether such fiscal stimulus helps is another matter. The underlying problem is loss of confidence in bank assets and liabilities. Until that confidence is restored we will have a continuing collapse of money, credit, output, and employment. Fiscal expansion has to be paid for out of higher future taxation. Fiscal expansion could therefore instead undermine confidence in the governments own balance sheet and make our problems worse not better.

1 comment:

Ralph said...

I agree with Eric Lonergan that a helicopter drop is needed at the moment. Eric wants a “a legal and institutional framework to do this on a more regular basis.

I doubt it will be needed on a regular basis. We didn’t need it in more normal times, e.g. between World War II and the start of the credit crunch. However, if we do need a “framework”, how about this.

We implement a law which says “The central bank shall have responsibility for deciding whether household balance sheets need bolstering.” (which they do as of Jan 2009) “If the central bank thinks the latter is required, it shall (1) inform the government of same,(2) credit an appropriate amount of money to the government’s account at the central bank and (3) the government shall use this money to finance its spending and will reduce taxation by the same amount.” There is bound to be something wrong with that, but its a start.

I disagree with almost all Alistair Milne’s criticisms of Eric.

First, I do not agree with Alistair Milne’s claim that money dished out by central banks is a liability for central banks. It appears as a liability on central bank balance sheet. But this is a fiction: it is a meaningless book keeping entry, as I seem to remember Willem Buiter pointing out. The Bank of England is under no legal obligation to give anyone £20 of gold or £20 worth of anything else in exchange for a £20 note. Or as “cdi” put it when commenting on one of Buiter’s posts “central bank balance sheets are about as meaningful as sidereal astrology” ( see

Second, as to Alistair Milne’s claim that some of the increased money supply will find its way back to the central bank as a deposit on which the latter will have to pay interest, this point is called into question by the fact that, as I understand it, the Bank of England used to have the power to demand deposits from commercial banks with no interest paid thereon. If the B of E no longer has this power, then it should: it is an excellent anti-inflationary tool.
Third, there is Alistair Milne’s claim that “The bottom line is that what Eric has in mind is simply a fiscal stimulus of the kind already tried...”. This is not true. There are big differences between the two, and as follows.

Eric proposes having central banks print money and dish it out. Period. In contrast, a fiscal stimulus consists of the “government – central bank machine” (gcbm) borrowing money in the market and dishing it out. (At least this is the case if the stimulus is funded, and since Alistair Milne says in his last para that the stimulus has to be paid for out of tax, he is obviously referring to a funded stimulus).

Of course the money dished out under Eric’s proposal may prove inflationary, and one anti-inflationary measure would be for gcbm to claw it back via taxation. In this case Eric’s proposal becomes a bit more similar to a funded stimulus, but the two are still very different.

Finally, I do not agree with Alistair Milne that “the underlying problem is loss of confidence in bank assets...”. Of course this is a big part of the problem. But at the same time, household balance sheets have been hit by falling house prices. I.e. governments need to attend to household balance sheets, not just commercial bank balance sheets (which is effectively what Eric is saying).