The Irreverent Economist

Some Unpleasant Monetarist Arithmetic

Monetary policy has reached a crossroads.  Neither conventional approaches to stimulating demand (low interest rates) nor unconventional policies (quantitative easing) have produced a durable recovery in the global economy, although they have contributed to a massive buildup in debt and rising disparities in income and wealth.


The predictable result has been a revolt by the citizenry, who are saying “Wait—What!?  Enough!”   The widening rebellion against the establishment proves the conjecture we made at this time last year:  That the monetary emperors have no clothes and would soon lose all credibility.  Indeed, if it were not for their guaranteed tenures, they might be thrown out of office, along with the rest of their elite cohort.  At least, one might wish…

Unfortunately, a new scheme is being floated, the idea of distributing “helicopter money” to the public à la Milton Friedman’s famous 1969 thought experiment.  In The Optimum Quantity of Money he asked:

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated…”

As Friedman explained, the purpose of helicopter money is to create inflation which, in the eyes of the modern central banker, is a good way to alleviate the real burden of debts, both public and private.  They will, of course, try to justify it as a way to stimulate spending and growth, although we are more likely to wind up with stagflation.  Keep in mind that one person’s debt is another’s asset, so inflation is generally not viewed as beneficial by investors.

Oh, it might support the stock market for a time, provided the authorities manage to keep inflation in a Goldilocks range that is neither too hot nor too cold.  However, the temptations of monetary finance grow with its successful use.  A credible prospect of higher inflation could provoke a major upheaval in global bond markets, given extremely low yields and the leverage associated with long bond positions.  As the interest burden of existing government debt rises, the pressure on the central bank to provide additional monetization would certainly intensify.  Equity investors, who have been discounting low interest rates forever, could be in for a rude awakening.

In a 2005 memo to colleagues titled Some Thoughts on Ben Bernanke, I wrote:  “Bernanke will be quick to embrace unconventional monetary measures (in the US and elsewhere) to prevent inflation from falling.  Because of the zero bound on nominal interest rates, he believes that the risks of a further decline in inflation are much greater than those associated with untested monetary strategies.  Yet falling prices need not trigger a deflationary spiral; it is the combination of falling prices and rising indebtedness that has proven dangerous in the past.  In this debate there often is an implicit assumption that rising debt ratios are a product of deflation.  Yet the influence may run the other way.  I worry that, by putting a concrete floor under inflation (at 2%), monetary policy will heighten the risk of an eventual liquidity trap by compressing risk premiums and contributing to excess borrowing.”

Well, here we are a decade later, with central banks having made good on their self-fulfilling deflationary prophesy.  As Tom Sargent demonstrated in his influential 1981 paper, once a country’s debt burden reaches an unsustainable level, the credibility of monetary policy is inevitably lost.  And once the credibility of the most powerful authority in government is lost, so is all the rest.

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