Eight years after the collapse of Lehman Brothers advanced countries are still struggling to find a way to return to a stable and sustainable growth path. This episode of deep depression and/or prolonged stagnation clearly puts at odds Robert Lucas’ daring conclusions back in 2003 that the “problem of depression prevention” is off the table. Lucas, lulled by a period of Great Moderation with stable growth and low inflation, was referring to then glorified rational expectations approach to macroeconomics implying that with vertical Phillips curve all what monetary policy ought to do is to follow a monetary rule proposed by John Taylor (1993). For monetary authorities, macroeconomic stabilization is relatively simple by following the monetary rule relating the nominal interest rate to inflation gap and output gap. The rule recommends an increase in interest rate when inflation is above its target or when output is above its full-employment level, and vice versa during the economic downturn. Agents with rational expectations will recognize these signals and react by decreasing investments and consumption during the period of tight monetary policy, which in turn will tend to reduce future inflationary pressure. To stimulate the economy during a downturn central bank will cut the interest rate, resulting in agents to react to cheaper money by investing and spending more and contribute to economic recovery by closing the output gap.
However, during the period of Great Recession after 2008 in advanced western countries, and two decades earlier in Japan, this monetary mechanism largely broke down. While monetary authorities engaged in these conventional monetary policies by reducing the interest rates to zero, agents failed to respond in the desired way by increasing spending and investments. Soon afterwards, some central banks, such as Federal Reserve, Bank of Japan and Bank of England, resorted to unprecedented unconventional monetary policies, such as quantitative easing and lately to negative interest rates on bank deposits. The European Central Bank (ECB) started with quantitative easing policy only recently, in March 2015. These unconventional policies, however, resulted in mixed results, modestly positive in the US and UK, but with essentially no effects in Japan and Eurozone. Economic growth and inflation failed to pick up in the Eurozone and Japan, while in the US and UK growth picked up, but not the inflation. Monetary policies, either conventional or unconventional, have failed to sufficiently stimulate aggregate demand.
Permanently depressed aggregate demand became the central problem of economic policies. In theory, however, depressed aggregate demand is not really a problem. Monetary authorities and governments can in principle create nominal demand in whatever quantity they prefer by deploying monetary financing, i.e. by creating and spending fiat money. It can be shown that with appropriate coordination between monetary and fiscal policies there is no reason monetary finance will lead to excessive inflation.
In this paper I explore a coordinated policy approach to stimulate depressed demand and pull the economies of western countries out of a current stagnation (or under par growth performance) and low inflation. I will explore the “helicopter drop of money” approach, proposed by Friedman (1969) and further developed by Bernanke (2000, 2003, 2016), Buiter (2003, 2014) and Gali (2014a, 2014b), as well as by a number of more recent papers (see also Reichlin, Turner and Woodford, 2013, McCulley and Pozsar, 2013, and Wren-Lewis (2014)). In the literature, this approach – characterized by increased fiscal deficits financed by fiat money issued by central banks – is known under a number of names, such as helicopter money drop, money-financed fiscal stimulus, monetary finance, etc. In this text I will use these different names interchangeably.
While there are different forms of monetary finance possible, ranging from increased transfers and tax cuts to households to infrastructure spending, the paper shows that technically they share the same characteristics and deploy the same mechanism of coordination between monetary and fiscal policies. The paper shows that monetary finance of fiscal stimulus can be a useful last-resort approach to boost economic growth in a liquidity trap when fiscal space is limited and when all conventional and unconventional monetary policies fail to provide desired stimulus. In particular, in the Eurozone this approach may be de facto the last-resort approach available to avoid the Japanese-style lost decade.
While technically manageable and potentially very successful, political opposition to this approach seems to be insurmountable. Nevertheless, the paper identifies two possible solutions that do not interfere with distributional and discipline issues in the monetary union. This is because they involve operations that may only ex post turn out to be monetary finance and which nature can be hidden or denied for years due to fear of legal and political challenges. Without the option of monetary-financed fiscal stimulus there may be no good way out of the present economic malaise and protracted period of lost development.
See full paper in the Journal of Money and Banking