‘T-Simps’, the nom de plume of a Cambridge undergraduate called Thomas Simpson, has a go at the paper Felix Nugee and I wrote and presented the day before yesterday on what we call ‘helicopter money’. I encourage you to skim over it if you haven’t already, before returning to luxuriate participate in its demolition discussion. Snark aside, it’s a great piece, and raises a lot of salient and controversial points. Highly recommended reading, and no doubt the start of an excellent blog. It’s just quite nice to have some conflict in the Cambridge blogosphere – or indeed to have a Cambridge blogosphere at all.
Without further ado, let’s take a look at Thomas’s arguments. From the top ….
(1) Negative interest rates can be a thing
Well, duh. Central banks can cut interest rates to negative infinity and beyond if they so choose. They have not and never will, because it would be pointless. This is because when interest rates are negative on any given security (say the bank balances which UK banks hold with the Bank of England), there’s almost no reason not to just withdraw its value into physical cash, which has a strictly better interest rate of zero. I say almost because there are costs to storing all that cash – think Fort Knox, bank vaults etc. Thomas rightly points out that Sweden has introduced negative interest rates. And the ECB might do the same. But no one – or almost no one – seems to think this would be more than marginally effective. Because once the cost of holding bank balances with the BoE at negative interest rates exceeds the costs of holding all that money in physical form, banks will withdraw it all. It’s that simple. In fact this is why when we are at the zero lower bound we call it a ‘liquidity trap’. Central banks are trapped by the fact that they can provide unlimited liquidity (i.e. money) without changing interest rates at all. Outsourcing to Barry Ritholtz on Sweden:
“Governor Stefan Ingves was quick to point out that benefits from negative interest rates did not seem to be observable. He did not get into the costs associated with negative interest rates, but he did affirm that it was unlikely that Sweden would use them again.”
The zero lower bound on interest rates is most definitely a problem. And this is why we need to reform. Or as Gotham City’s Caped Crusader once put it:
2) It’s not about the state of financial intermediaries. It’s about expectations of future nominal income
I’m confused about this point on a number of levels. Firstly, we have absolutely no problem with nominal GDP level targeting (NGDPLT). In fact, I think (and Felix agrees) that NGDPLT would be a wonderful initiative. It is, however, a different argument – one that we’d fully support, but well outside the scope of our proposal (I seem to remember Felix making this point in our seminar). Most of the people who support NGDPLT (e.g. Michael Woodford, David Beckworth ) are very keen on seeing the two policies as complements, as are we.
But that notwithstanding, it is simply not true to claim that you could fix a broken financial system solely by stabilising future expectations of nominal income, which is I think the main line of Thomas’ and others’ arguments. It requires a world that is fundamentally at odds with what happened during the financial crisis. It is a world in which banks were willing to borrow from other banks, because they were not afraid that whatever collateral they received might be worthless in a few days time. It is a world in which banks were willing to lend to other banks because they were not worried about the prospect of them going bust. It is a world in which hot money didn’t take flight from the banking system and leave them without funds to lend at all. It is not the world we’ve been living in for the last five years. Instead, it is a world with a financial system that chose to stop lending because of future expectations, and was not forced to stop lending because of current financial panic. When Northern Rock had depositors queuing outside its cash machines in 2007, when RBS was scrabbling around to fund itself after buying the basket case that was ABN Amro in 2008, whatever the Bank of England might have done to the future economy was irrelevant – they simply did not have the balance sheets in place to lend out to the real economy. And so Felix and I remain sure that the financial system was sufficiently bust over the crisis that, we need other ways to target the real economy, which don’t rely on merely stabilising nominal income expectations and trusting to the health of the banking sector.
3) Can QE or forward guidance cause bubbles?
Admittedly I’m not entirely convinced of this point myself, and lots of evidence points against the UK currently being in a bubble. But I’m certainly concerned about the possibility – and who wouldn’t be? We know from the last five years that the small tail risk chance of a bubble is worth weighing, because the consequences are so catastrophic. But Thomas claims to be confused about it, so I’ll try and point him in the right direction. The gist of the battleground here is this: when QE and forward guidance happens, what happens to long-term interest rates? And if long-term interest rates fall, why would that cause a bubble?
This next bit is quite tedious, but it’s Thomas’ argument as best I can make it. There’s supposedly an effect that says interest rates should go down. Some people call this the ‘liquidity effect’. The idea here is that QE or forward guidance lowers the path of future short-term interest rates, and this makes long rates fall. There are also a couple of effects that putatively act in the opposite direction. These are called the ‘inflation’ and ‘income’ effects. These reflect the fact that in the long run, if the economy picks up because of the stimulus, inflation and growth should rise, so the central bank will eventually raise interest rates.
Now I have no idea which of these effects dominate. I have no idea whether any of them are correct. They could both all be powerful or all be weak. We could have totally the wrong model of the economy and financial markets and how monetary policy works (and the evidence seems to be pretty clear that we do). This Scott Sumner bloke who Thomas brings up doesn’t have a clue either. And armchair theorising won’t get you there. You have to actually look at interest rates to figure out what’s going on. I took the precaution of actually doing this:
So the bulk of QE took place in the October 2011 to July 2012 phase – right next to that nice big cliff in the middle. We had a bit in November 2009, just before the slightly smaller valley to the left. The rest took place in the flattish 2009-2010 phase. But you might say that just eyeballing interest rates isn’t particularly persuasive. Fortunately some very smart people have already done much more careful analysis. Paul Tucker, BoE deputy governor is probably the best the UK has on this front. And he like others finds that unconventional monetary policy has acted to lower long-term interest rates. Which, you know, accords well with just about every piece of serious econometric work on the subject.
So why is this a problem? The issue is that when long term interest rates fall, financial intermediaries who need to make some kind of fixed return on their investments (think pension funds who need to provide steady returns to people drawing down pensions) take on riskier propositions that pay a higher yield. In the parlance, they ‘reach for yield’. And this could create problems further down the road when either (a) these risks all blow up in their face or (b) they all unwind the risky investments when interest rates normalise. In fact there’s a very good case to be made (and Jeremy Stein of the Fed makes it) that this was in large part a reason behind the erratic movements in interest rates over the summer. Now I hasten to add that we don’t have a very good idea of whether or not this ‘reach for yield’ thing matters at all. But one lesson we’ve learnt about finance over the last five years is that trying to poke institutions into overleveraging themselves is something that we should do our best to avoid if we can.
For the record, Thomas’ point about targeting foreign currency is an excellent one. But I digress ….
3) Income inequality
Not even sure how to argue this point. We have a choice between (a) a way of stimulating the recovery by raising the incomes of the few and hoping they trickle down; or (b) raising the incomes of the many. The latter is preferable on this basis. Period. Sure, QE may have raised asset prices because it raises current and future profits. But this is basically the point Felix and I made – poor people don’t own assets so they don’t benefit from this.
Whew. Almost there. I need to sleep.
4) Will helicopter money work at all?
This is a very important point – and one we communicated very badly in the paper and also when we presented it, as Thomas rightly points out. The point made is this; we hope that by design helicopter money would function like a temporary tax cut. So what if consumers simply saved the money or paid down debts, instead of using it to boost spending? We have two answers to that. Firstly, recoveries after financial crises are generally slow because consumers are paying down debts – or ‘repairing balance sheets’ in the jargon. One of the better aspects of helicopter money is that if consumers chose to use it to get rid of these debts, it would accelerate the process of balance sheet repair, and speed the UK along the path towards recovery. That aside, though, if consumers are busy saving or paying down debts with their helicopter-dropped money, the idiot-proof solution is to simply give them even more money. Which is the crux of our explanation.
I guess that’s pretty much everything. A series of very important criticisms from Thomas, but ones which Felix and I think our policy is broadly robust to. People who have made it this far in either of our posts may have also realised that the debate is something of a proxy argument over what Thomas calls ‘market monetarism’. I happen to take a much glummer view of that particular school of thought than he does (having once been a devout myself), but this is an argument for future blogging wars.
 Respectively, the man famous for working out all of the interesting ideas of the obscure school of thought known as ‘market monetarism’ about a decade before it existed; and the most financially literate and arguably most incisive of the aforementioned market monetarists.