Eco-Economy: Helicopter Money
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Helicopter Money, Or The Road To Weimar?
by Marshall Auerback
November 26, 2002
Last April we drew attention to a Financial Times piece which discussed Federal Reserve officials’ worries of short term interest rates being so low that monetary policy would be rendered ineffective. The report went on to moot further ‘unconventional’ policy measures to offset this impending difficulty. At the time, we made educated guesses as to what these measures might entail and suggested that they would initially:
“remain covert providing that a sufficiently large critical mass of fund managers understood that there were support mechanisms at work in the market. The references to ‘unconventional measures’ in the FT article help to create this ‘understanding’.
Such an implicit understanding on the part of these managers would facilitate their ability to trade on the back of periodic covert interventions, thereby supporting government objectives. In these circumstances, policy makers would likely do nothing to disavow such a belief (and might in fact quietly encourage it), since the herding dynamics of these portfolio managers would enhance the authorities’ objective of supporting the market. Only after this option has proved wanting would the authorities move to explicit intervention.
Why explicit? The public does not react to inferences and hidden coded messages by America’s leading policy makers in the way in which a professional fund manager well attuned to the vagaries of the market would. The vast majority of private investors react adaptively to historic price trends. If returns for the equity market continue to disappoint (as they generally have over the past 2 years), the adaptive expectations of the public in regard to their expected returns for equities will diminish, creating widespread redemptions and ongoing selling pressure. The belief in the efficacy of the Greenspan put will accordingly begin to dissipate. Mr. Greenspan has told us since his Jackson Hole speech in 1999 that if the incipient dynamics of panic and crash reoccur (and thereby further threaten equity wealth and, by extension, consumption) the Fed will respond, and this time with a more explicit and transparent rationale.”
Recent statements by the Chairman of the Federal Reserve, Alan Greenspan, and a prominent Federal Reserve governor, Ben S. Bernanke, suggest that we are at last in the final stages of this process. Speeches by both gentlemen kindly spell out exactly the sort of explicit and transparent rationale required to engender the final moral hazard melt-up in the capital markets. Be careful what you wish for: Deflation may be averted, but if we are to take the proposals sketched out by these Fed officials at face value, the increasingly extreme outcome that lies in store for the US economy may be one of two equally unpalatable scenarios: a degree of socialisation unheard of since the days of the old Soviet Union or a Weimar Germany-type hyperinflation.
During unprepared remarks after a recent speech to the Council on Foreign Relations, Alan Greenspan once again reiterated before a microphone, this time with much less diffidence than he has hitherto expressed, his conviction in the ability of the Fed to engage unconventional methods in the war against deflation. Interestingly enough, he was responding to a question posed by Don Marron, who was once considered a potential candidate as Treasury Secretary under Bush II. These remarks went unnoticed by most of the press, but here is the full transcript reported by Bloomberg:
(UNKNOWN): All right. Yes, at this table. Mr. Marron (ph). Please state your name and affiliation for the record.
(UNKNOWN): Don Marron, now Light Year Capital (ph). Alan, thank you for encouraging all of us that there are going to be higher rate of return on the future of investments. That's a great start in all of this.
The last cut in interest rates of half a point presumably limit your flexibility in using further rate cuts to stimulate the economy. What other actions would you advocate if the economy does not move forward as predicted? Particularly -- and you might comment on the big issue of growing state and city deficits.
GREENSPAN: Well, first of all, there's a general view that as the Federal Funds Rate gets closer and closer to zero that at zero we are out of business. That is not the case. We have a whole set of Treasury bills, bonds, and notes that go out a very long number of years which are yielding -- if we were down to zero would still be yielding quite significant interest rate levels so that we would just move out on the curve and we would be functioning as indeed we have in the past.
People don't remember that from 19 -- I think it was 1942 through 1951 when the Treasury -- when the Fed Treasury accord took place. We essentially, at the Fed, supported 25-year Treasury bonds. We fixed them at 2.5 per cent. So you could imagine how many Treasury bonds we accumulated as a consequence of that. So there's -- we are very far from the Fed being restricted because we are, I'd just as soon not answer the next question.”
That this blatant advertisement for public debt monetization as the ultimate solution took place at a speech before the Council on Foreign Relations – the very same organisation that ran financial stability war games beginning in 1999 ostensibly to prevent or contain the equity bubble from blowing up — is more than coincidental, to say the least. But it fits in with a general theory of moral hazard in which the monetary authorities might be forced to move toward ever greater levels of intervention in order to “retain” financial stability (whilst in reality doing precisely the opposite).
Since this represents Greenspan's second mention in as many weeks of unusual measures available to the central bank as short term interest rates approach zero, he appears to be laying the public groundwork for the long mooted “unconventional policy measures” first flagged in a paper dated November 27, 2000, “ Monetary Policy When the Nominal Short Term Interest Rate is Zero”, by professors James Clouse, Dale Henderson, Athanasios Orphanides, David Small, and Peter Tinsley, all advisors to the Federal Reserve. These authors all take a “broad constructionist” approach to the powers laid out in the Federal Reserve Act, in effect concluding that what is not explicitly prohibited by the legislation empowering the central bank enables the Fed to do whatever it wants in “unusual and exigent circumstances”.
But Greenspan’s remarks are no where near as explicit as his some of his Fed colleagues, notably Ben Bernanke in his November 21st speech to the National Economists Club in Washington, D.C., “ Deflation: Making Sure ‘It’ Doesn't Happen Here”. Reading the speech, it is worthwhile noting how many times the foregoing Fed paper by Messrs Clouse, Henderson, Orphanides, Small and Tinsley is footnoted by Bernanke. Clearly, the November 2000 paper was not simply meant to collect dust in the ivory towers of academia. After blithely reiterating the now commonly heard refrain that there is no deflation evident in the US, Bernanke nevertheless issues a broad checklist of measures available to the Fed, currently and prospectively, to fight deflation:
“I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.
A principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero. In the remainder of my talk, I will first discuss measures for preventing deflation--the preferable option if feasible. I will then turn to policy measures that the Fed and other government authorities can take if prevention efforts fail and deflation appears to be gaining a foothold in the economy.”
First and foremost, Bernanke makes virtue out of necessity, in effect celebrating the onset of fiat currencies, where money is backed by nothing more than the power of the state to impose taxes, and “the logic of the printing press”. We cannot recall another instance of a monetary official actually celebrating the central bank’s ability to destroy the intrinsic value of a currency:
“As I have mentioned, some observers have concluded that when the central bank’s policy rate falls to zero - its practical minimum - monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero…
The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.
What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation… If we do fall into deflation… we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”
Bernanke says the first line
of defence in executing this "logic of the printing press"
is, as the “maestro” foreshadowed, for the Fed to extend out
the maturity of the Treasuries it purchases in conventional
open market operations. 2 year, 5 year, or 10 year Treasury
bond yields could be pegged at the Fed's desired level. The
US and Britain did it in WWII, as did the US
during the Vietnam conflict:
“Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior). Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys…what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).”
In the following paragraph, note Bernanke’s explicit reference to the period preceding the Federal Reserve-Treasury Accord of 1951 – precisely the same accord to which Greenspan made reference in his comments to the CFR earlier in the week. There is a clear co-ordination of signals being sent to the marketplace:
“Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade.
Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills.
Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding. For example, the Fed held 7.0 percent of outstanding Treasury securities in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of outstanding Treasury debt.
The second line of defence is for the Fed to "consider attempting to influence directly the yields on privately issued securities", just in case corporate and mortgage bond spreads widen when the first line of defence is executed. For as Dresdner RCM strategist Rob Parenteau surmises, many of these same people would have to believe they would be given the increase in inflation premiums that would be required by fixed income investors owning non-governmental fixed income instruments during a time when the Fed was monetizing Treasury bond debt. This step would include the following:
“[A] second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.”
The third line of deflation defence would be for the Fed to buy foreign government debt, as well as domestic government debt:
“The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.”
Of course, as Bernanke quickly recognises, the latter policy has definite shortcomings. There is “beggar thy neighbour” aspect to it via the resulting depreciation of the dollar as the Fed prints dollars to bid for non dollar denominated foreign government bonds. There is also the awkward climb out of former Treasury Secretary Robert Rubin’s “strong dollar box” at a time when US markets are increasingly held hostage to speculative overseas short term portfolio flows; in fact, 40 per cent of Treasuries are now held by foreigners, who may not take kindly to a hinted policy of explicit devaluation and who may, therefore, move to counteract the effectiveness of the measures introduced by the Fed (e.g. by demanding a higher long term interest rate to compensate for the resultant capital loss that would stem from a dollar devaluation). Bernanke clearly senses as much as he promptly disavows the implication that he is calling for an abandonment of the “strong dollar” policy (reiterated again just weeks ago by the President’s chief economic advisor Lawrence Lindsey):
“I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.”
Although Bernanke seeks to assure America’s foreign creditors that a policy of intervening to reduce the external value of the dollar is nowhere on the horizon today, his subsequent statements do not provide any great crumbs of comfort for them. It is noteworthy that Bernanke’s speech goes on to cite approvingly one conspicuous instance in which he claims that exchange rate policy has been an effective weapon against deflation, namely FDR’s decision to abrogate the gold standard in the US and immediately expanding excess reserves in the banking system as an unintentional byproduct.
We should all take pause and consider the implications of a Federal Reserve governor implicitly sanctioning Roosevelt’s breach of private contracts, the very basis of free markets. But the ends seem to justify the means. After all, as Bernanke tangentially notes, “1934 was one of the best years of the century for the stock market”. And that’s all we really need to keep investors happy!
The whole of this interesting period is recounted fully in Friedman & Schwartz’s “ A Monetary History of the United States”. A couple of days before giving this speech, Mr Bernanke gave a tribute to Dr. Friedman in which he described his understanding of that book and the 1930's. Needless to say, the subsequent speech reveals that this was not the only possible interpretation of the tribute.
According to Friedman and Schwartz, during the Great Depression from 1929 to 1933 nominal money fell by 33% and nominal income fell by 50%. Prices went from a stable level to a 7% average annual rate of decline. All private assets were perishing; perceptions of risk were sky high. Money's relative risk adjusted rate of return soared. The decline in the income velocity of money and the relationship between changes in money and changes in nominal income were highly consistent with the standard monetary framework.
In 1933, with the revaluation of gold, the US monetary base rose dramatically. From 1933 to 1937 the monetary base rose by 60% and the money stock rose by 51%. Nominal income growth followed, rising 14% on average over the four-year period. As deep deflation gave way to 2% average annual inflation, the income velocity of money increased.
We recognise that there are competing historical interpretations of the period. Suffice it to say, even if one embraced the Friedman analysis, the analogy does not hold up well in the context of today’s financial system. As our colleague Doug Noland has consistently demonstrated, we no longer have a credit system moored to anything remotely approaching a gold standard. Noland contrasts the Fed’s comparatively miniscule balance sheet today “next to the soaring Mount Everest of financial claims. Last week’s total Federal Reserve Assets of $685 billion compare to total outstanding Credit market debt surpassing $34 Trillion. The antiquated and feeble helicopter will need to be replaced with a large fleet of super-jumbo cargo airships.” It is even more complex when so much of that debt is held by capricious overseas investors who may not sympathise with some important domestic objective to be achieved through government.
Which should induce some hesitancy on the part of Mr Bernanke, but merely seems to encourage him to go further down the unconventional road to something that more closely approximates a something out of the old Soviet Union, or Mussolini’s fascist Italy:
"Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with the newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets."
Perhaps one should applaud Mr Bernanke for being so forthright in laying out the Fed’s objectives. It all seems so easy as a final solution to deflation: the Treasury buying private assets of any kind, financed by Treasury debt monetized by the Fed. Maybe this is how the stock market is ultimately “rescued”? It is worthwhile considering these proposals in the context of Denis Mack Smith’s account of fascist doctrine in Mussolini’s Italy (“ Modern Italy: A Political History”, Yale University Press 1997”):
“In July 1925 [Minister of Finance] De Stefani was replaced by the financier and industrialist Count Volpi and many vested interests at once began to profit from protection and central planning…when Count Volpi…took over the ministry of finance there was further talk of scandalous relations between banking and politics. The industries of the Ansaldo group, which had collapsed in 1921, lent support to a government that would stimulate armament production and ‘nationalise’ their losses. A new steel cartel arose in the early thirties which helped to keep inefficient firms alive, its express intention being to maintain high prices and control production, and consumers thus subsidized inefficiency in order to prevent a large uneconomic investment from losing its value. With such help, the Edison electricity company, Montecatini chemicals, Snia Viscosa artificial silk, and Pirelli rubber lost none of their dominant positions. The Agnelli family, which controlled Fiat, became responsible for four-fifths of Italian automobile manufacture, as well as for numerous other operations than ranged from mining and smelting to making vermouth, cement and newspapers. These were private concerns. The Italian economy under fascism was not typified by direct state ownership, but in 1933 the Istituto per la Ricostruzione Industriale (IRI) was founded by the government to subsidize ailing industries and save those banks that had been too liberal in giving long term credit…”
Does this sound like a far-fetched comparison? Perhaps so, but not if we are to follow Bernanke’s own policy prescriptions to their fateful conclusion. We are not seeking to draw a direct comparison between fascist Italy of the 1920s and 1930s and America of the 21st century, so much as we are trying to illustrate what happens to an economy when vested financial interests begin to profit from undue socialisation of risk.
We leave the final word to Rob Parenteau:
“Discussing the role of the Federal Reserve, the late economist Hy Minsky determined, during periods of financial instability is always and everywhere to place a floor on asset prices through lender of last resort functions, and if possible, to elevate that floor price to the level necessary to get the market value of the existing stock of capital equipment and structures to a high enough premium relative to its replacement cost (Tobin's Q) that entrepreneurs and financiers would see enough of an arbitrage opportunity to begin reinvesting.
The problem that has always bedevilled post-war economists that have understood this view is how the Fed could actually achieve this goal. The answer for the most part has always been along Tobinesque portfolio balance lines — if the Fed creates enough money, savers will be forced to rebalance some of their excess money holdings into equities and corporate bonds to get the same marginal utility from each asset class of wealth holdings. But this has never been a sufficient answer, as liquidity preferences can become extreme in periods of rapid capital losses on stocks and corporate bonds and deep, fundamental uncertainty. We can now see, with this elegant admission by Governor Bernanke that this problem has been well thought through, and may in fact have been solved. With the Fed as lender of first resort to the Treasury, the government becomes spender of last resort on private capital equipment and structures, not just public roads, dams, bridges, and unemployment compensation.”
Perhaps unwittingly, Bernanke offers us a clue as to why tech, telecom, and finance have led the rally since October 9th — perhaps these are the commanding heights of the US economy due to be socialised first with this new variant of open market operations during what may very well prove to be the endgame of the dollar reserve system.
Monetary systems are born in crisis and die in crisis, the crises stemming from the errors of central bankers and those whom the central bankers nurture, regulate, and increasingly bail out. The increasing resort to moral hazard, the resultant socialisation of risk, even on the ostensible grounds of preventing a socially crippling deflation, ultimately becomes untenable: there are no clear guidelines or principles governing the practice, thereby destroying the very economic system policy makers seek to protect.
In the United States today, the fear of deflation is a green light for money printing and now, it appears, all sorts of other unconventional policy measures as well. They appeared rooted in no coherent ideology, other than an increasingly aggressive effort to inflate. As Denis Mack Smith himself notes, “Fascism began with no particular economic policy: its doctrines of planned economy were one to day to be called typically fascist, but in fact they came as an afterthought”. Much the same applies here. At the very least, Bernanke and Greenspan have provided the most powerful argument possible for owning gold, assuming of course, that this subversive practice is not abolished as the Fed and government mobilise to defeat a supposedly non-existent deflation. In so doing, they leave us less concerned with the prospects of deflation and more aghast at the apparently limitless measures America’s financial and monetary officials appear prepared to countenance sustaining an increasingly unsustainable system.