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Next recession may see merger of fiscal and monetary policy

MACRO policymakers are in a mood to leave well alone. The advanced economies seem likely to grow at close to their trend rates in 2020, despite the temporary shock from policy interventions to slow the spread of the coronavirus. Recession risks are still low.

However, economists are becoming increasingly exercised about the problems that will inevitably surface when the next recession comes along. It is widely accepted that the forms of monetary action used in the last decade to combat recessions are now severely circumscribed.

Although some central bankers have been reluctant to admit that their cupboard is almost bare, former US Federal Reserve chair Janet Yellen accepted the reality this month: "I worry about low interest rates because they are a symptom of a deeper problem in the global economy. And it has put central banks in a position where they don't have a lot of ammunition. If we have a serious recession, we're probably not going to be able to count on central banks to offer up a significant response."

So, are there are even more unconventional forms of monetary stimulus that could be applied during the next downturn, either independently or in conjunction with fiscal policy? Here, there is no consensus.

When global interest rates fell to their effective lower bound in the mid-2010s, some economists argued that the monetary authorities had the ability to "print" and distribute money to households in order to restore the growth in aggregate demand. Equally, they could create central bank reserves to purchase enough public debt to finance any amount of fiscal stimulus desired by the government.

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Support for helicopter money in either of these forms never really became mainstream among policymakers because of concern that aggressive use of central bank balance sheets could eventually unleash much higher inflation expectations, which would be very costly to bring under control.

These inflationary dangers have now diminished, and would decline further in a recession.


But any enthusiasm for helicopter money as an independent instrument of the central bank has been dashed by a growing realisation that it can be viewed as a form of fiscal policy, not monetary policy. This raises inevitable questions about whether it would genuinely alleviate the government's financing constraint, and how it should be related to the decisions of the fiscal authorities.

When the Fed injects liquidity into the financial system, it does so by crediting private banks with additional central bank reserves, in exchange for bonds or other assets. Following reforms in 2008, interest rates are paid on the reserves held by the private banking sector at the Fed - as happens in other countries. Since central banks are wholly owned by their governments, their balance sheets should be consolidated fully into the public sector.

These reserves are therefore equivalent to interest-bearing loans from the private to the public sector, a form of public debt almost identical to the issuance of Treasury bills by the government.

This principle was explained by Narayana Kocherlakota in 2016, and now seems to be broadly accepted by many mainstream macroeconomists, though it is not generally acknowledged by policymakers.

There are two extremely important implications:

  • Pure monetary financing of budget deficits is more restricted than is assumed by the proponents of helicopter money. It can be done by printing extra banknotes, but the scale is severely limited by the private sector's willingness to hold physical cash instead of bank deposits.
  • As David Mericle of Goldman Sachs explained in research for clients last week, almost anything that can be achieved by an expansion in the central bank's balance sheet can also be achieved by the fiscal authorities. For example, the finance ministry could issue Treasury bills to fund an increase in the budget deficit, without involving the central bank. This would change the overall composition of public-sector liabilities just as if the central bank financed the deficit by increasing reserves.

Gertjan Vlieghe, external member of the Bank of England monetary policy committee, recently summarised the situation as follows: "If the central bank pays interest on reserves, helicopter money is really just a fiscal expansion, financed by interest-bearing reserves. Interest is still payable. It is not that this would make it ineffective, it is just that it makes it little different from debt-financed fiscal expansion, other than unnecessarily making the central bank more involved in fiscal policy."

This conclusion, which is fully justified, suggests that the next global recession may result in a merging of what has traditionally been viewed as the two separate wings of macro policy, fiscal and monetary.

It is a difficult question of political economy whether the central bank or the treasury is better placed to lead the design of an effective policy response in this environment. Japan has been in this position for several years and has so far failed to cut the Gordian knot.

Policymakers in the US and Europe should be thinking well in advance about how they can co-operate both internationally and domestically to produce a better outcome. There is no sign of this happening yet. FT

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