We don’t need helicopters for better monetary policy
by Josh Ryan-Collins | @jryancollins
Monetary policy is back in town. Kind of. The Bank of England has raised interest rates above 0.5% for the first time in almost a decade (to a historically still extremely low 0.75%). The decision was met with consternation by many commentators. In theory, raising rates increases the cost of borrowing for households and firms and hence dampens economic activity. In the face of on-going national and global economic uncertainty, the timing seemed puzzling, but the bank claimed it had little choice given definite, if faint, signs of wage inflation.
In the larger scheme of things, however, a quarter point rise in rates will have little material impact on the economy. The bigger question facing central banks is why didn’t the swift and very large reduction in interest rates (from 5% to 0.5% in the UK) that followed the crisis and the huge quantitative easing (QE) money creation programmes (in the UK £445bn so far) that followed once rates had reached near zero not return economies to health more quickly? And, relatedly, with interest rates seemingly permanently lower, what are central banks going to do when the next crisis arrives?
The emerging favourite alternative ‘tool’ for central banks is ‘Helicopter Money’. First proposed by Milton Friedman in 1969, the idea is to exploit the central bank’s money creating power to fund a permanent one-off increase in household incomes. In Friedman’s analogy money is dropped in to households from the sky but today it would be a case of electronically crediting customer bank accounts or giving everyone a one-off tax-cut, both financed by the central bank.
The theory is that this would be more likely to boost consumption than an increase in government spending, or a tax cut, financed by borrowing. This is because ‘rational’ households would know that a stimulus funded by government borrowing would eventually require the government to raise taxes to reduce the deficit back when the good times returned (the ‘Ricardian equivalence’ problem in the economics jargon).
Putting aside the problem that governments with sovereign central banks and currencies cannot ‘go bust’, this theory relies on households being able to see far in to the future and make rational decisions that optimise their welfare. The rational expectations hypothesis has been the subject of considerable criticism in the post-crisis period. Despite this, the same kind of thinking was behind standard QE. Central banks believed that if they bought up government securities from financial institutions (such as pension funds and insurance companies) and replaced them with zero-interest yielding new created money, those institutions would ‘rationally’ decide to invest the money in higher yielding assets like corporate bonds. In turn, this would reduce firm’s borrowing costs and encourage them to invest in the real economy, stimulating growth.
There has been little evidence of this happening in the UK. Business fixed capital investment remains below its pre-crisis level as a percentage of GDP, despite ultra-low rates, and well below the UK’s competitors many of whom did not engage in such large QE programmes. There is more evidence of investors and firms using the new money to buy existing assets, such as property or shares, including their own shares, pumping up the stock market and real estate market but doing little to enhance productivity or innovation.
The idea of Helicopter Money is to make the ‘transmission mechanism’ more direct by injecting the money directly to households. It is perhaps true that households will be more likely to spend new money on real economy goods and services than institutional investors. But, given the aforementioned uncertainties, those that can afford to might well choose to save a large proportion of this money or, again, use it to fund the purchase of property or other non-productive assets.
The other problem with Helicopter Money is that is that it focuses on household consumption as the tool by which to inflate the economy. But the UK is desperately in need of investment and innovation-led growth, not more consumption-led growth which is associated with high household debt levels and a widening current account deficit.
Fundamentally, the UK’s macroeconomic problems are not related to the amount or cost of money (the interest rate) but more to its allocation in the economy. Indeed, as the Institute for Innovation and Public Purpose (IIPP) argues in a new policy brief critiquing QE, the evidence suggests businesses — whose investment is most needed for productivity improvements — are less sensitive to interest-rate changes than households. Rather, firms will invest when they believe there is an opportunity for profit to be made. What has been lacking since the crisis is not so much the supply of money but demand for it go to in to the areas that will create sustainable economic growth.
This raises the bigger question of whether fiscal policy (government taxation and spending), industrial policy (where the money will be spent) and monetary policy could be better coordinated.
The majority of economists have argued that the recovery could have been much faster had governments used the very low interest rates on government debt that QE produced to spend more. However, most Western governments did the opposite, believing the private sector would step in and start investing given the ultra-loose monetary policy of central banks. Since central banks guard their independence from government fiercely, it’s difficult to know whether they supported or rejected austerity policies, In any event, the private sector didn’t step in.
In a new IIPP working Paper, Bringing the Helicopter to Ground, written with Frank van Lerven of the New Economics Foundation, we undertake a historical review of fiscal-monetary policy coordination with a specific focus on forms of monetary financing that actually happened in the 20th century. None of these involved a ‘helicopter drop’.
Using IMF data on 13 advanced economies, we find that between the 1930s and 1970s, governments required monetary institutions — including both central banks and commercial banks — to finance government spending through directives, regulations and formal and informal negotiations. Indeed, for the 30 years that followed World War II, almost half of government debt was held by monetary institutions (see figure 1).
Figure 1: Composition of ownership of government debt averaged across 13 advanced economies, 1900–2011
Monetary financing was an important means by which governments were able to reflate economies following the Great Depression; finance World War II and the reconstruction that followed; and support ambitious industrial policies and full employment — despite high initial public debt-to-GDP ratios. Because the interest paid to central banks by governments on their debt was returned to them (as central banks were publicly owned) this also helped reduce the debt. Specific examples of fiscal-industrial-monetary policy coordination we highlight in the paper include:
- The Federal Reserve, via the US Treasury, helping to finance the publicly owned Reconstruction Finance Corporation — at the time the worlds’ largest bank — to support Roosevelt’s New Deal Policies to help the US out of the Great Depression
- The Bank of Japan helping to finance a massive government investment in public works and industrial production in the mid-1930s
- The New Zealand central bank financing the building of social housing in the early 1930s
- The central bank of Canada financing the creation and capitalisation of an Industrial Development Bank in 1945 which went on to support small and medium sized enterprises across Canada for the next 30 years, providing almost a quarter of total domestic bank lending to businesses by the 1960s
Central banks during this period had less ‘independence’ and broader mandates — with inflation just one amongst multiple objectives — than they have today. Whilst strong independence is widely viewed as vital to keep inflation under control, during the period of fiscal-monetary coordination in our study of western economies the only major incidence of inflation was in the 1970s and early 1980s. This was a period when a number of external events, such as the collapse of Bretton Woods and the oil shocks, would seem a more likely explanation for rising prices.
The current debate on reforming monetary policy — dominated by the Helicopter Money discourse — places too much emphasis what ‘rational’ households might or might not do with some extra cash. In doing so, it neglects the possibility that better fiscal-monetary policy coordination — along with an active industrial policy — might help support a more mission-oriented policy agenda that directs public money and patient capital in to those areas of the economy where it is most needed, with significant economic multiplier effects. State Investment Banks could play a key role here as IIPP has demonstrated in previous research.
Helicopter drops have captured the imagination of the public and economists. But history shows us that the great levers of macroeconomic policy can work in tandem to create sustainable economic growth without the need for such emergency measures. By doing so, we might be better prepared for the next financial crisis.
Read the latest working paper from IIPP: Bringing the helicopter to ground: A historical review of fiscal-monetary coordination to support economic growth in the 20th century
Read the latest policy brief from IIPP: The effectiveness and impact of post-2008 UK monetary policy
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