Since the beginning of the global financial crisis, many central banks have tried unconventional monetary policy and the results have not been great. The Federal Reserve’s quantitative easing program arguably gained some traction on its third attempt, but efforts by the European Central Bank and Bank of Japan have been in vain.
There are a range of issues with unconventional monetary policy, particularly when operating against the zero lower bound, but the biggest one is that central banks don’t get much bang for their buck. For all the trillions poured into the global financial system over the past six years, very little of it has found its way into the real economy.
But what choice did policymakers have? Interest rates were already at zero per cent -- or close enough to -- and government debt rose so quickly that it created its own crisis. Raising taxes was not an option and undesirable in any case.
However, there was another way -- unconventional by modern standards, but with a long and colourful history -- why didn’t governments simply monetarise fiscal policy? Why didn’t governments from the United States to Europe, the United Kingdom and Japan simply print more money and spend it on government services, infrastructure projects or simply drop it from helicopters?
That’s the question posed by academic Jordi Gali in a recent paper, The Effects of a Money-Financed Fiscal Stimulus. The very idea of a government printing more money to stimulate the economy or repay their debt is somewhat taboo, sacrilegious even, and yet in the presence of the zero lower bound, it makes a lot of sense.
Contrary to conventional wisdom, the research finds that a temporary fiscal stimulus financed through creating more money has a strong effect on aggregate demand but only a minor effect on inflation.
Unlike quantitative easing, a money-financed fiscal stimulus has a direct effect on aggregate demand and therefore output and employment. While the effectiveness of quantitative easing rests on the financial system, confidence and animal spirits, there is no shortage of literature that confirms that households will spend stimulus payments and infrastructure projects will increase employment.
The main downside of a money-financed fiscal stimulus is the risk of increasing inflation and inflation expectations. But during a crisis is that really a risk? And why should we be more concerned about printing money for government spending than we are about printing money and handing it to the banks?
Gali finds that when prices and wages are completely flexible, “such fiscal intervention has a very small effect on economic activity and a huge, heavily-frontloaded impact on inflation.” That’s the narrative that thousands of economic students learned during their studies -- hyperinflation in Weimar Germany and, more recently, Zimbabwe are the classic case-studies.
But in the real world, prices and wages are often quite rigid and changed infrequently.
Hyperinflation is still possible, but unlikely, in developed countries with a credible monetary regime. Gali finds that in a model economy using realistic price rigidities, “a money-financed fiscal stimulus has very strong effects on economic activity, with relatively mild inflationary consequences.”
Perhaps more importantly, Gali finds that money-financed fiscal spending has a larger impact than debt-financed spending. Finally, if the economy is sufficiently below full-employment -- as remains the case in most developed countries -- “a money-financed fiscal stimulus may raise welfare even if based on purely wasteful government spending.”
The takeaway point is that monetarising fiscal spending has some distinctive benefits during a period of crisis. The twin concerns of rising inflation and interest rates -- as a result of crowding out private sector spending -- are largely irrelevant in the presence of a liquidity trap.
The most important implication in my view is that money-financed fiscal expansion provides one way to tackle the long-term implications of a prolonged recession. Recent research by Laurence Ball from John Hopkins University showed that the global financial crisis had fundamentally reduced the long-run sustainable growth rate for most developed countries (Lessons for Australia from the GFC; June 11).
The long-term effects of a recession can be varied but generally result from a decline in capital accumulation, technological progress and skill atrophy among the unemployed. The end result is that the productive capacity -- or potential growth -- of a country either declines or slows significantly.
Quantitative easing was pursued not only to support the financial system and lift near-term growth, but also to reduce the long-term damage of the crisis. The same can be said of conventional monetary and fiscal policy. Of the three approaches, none were up to the task and quantitative easing remains the only one that wasn’t quickly exhausted.
Money-financed fiscal spending changes that because it cannot be exhausted and can be fine-tuned to directly address the short-fall in aggregate demand. It’s not subject to debt constraints but economic constraints; printing additional money only becomes a bad policy when the crisis is averted and the economy is no longer in a liquidity trap.
It also has the benefit that it places the stimulus in the hands of those most likely to spend and invest the money. The banks caused the mayhem through negligence and incompetence, and yet, for six years central banks have simply handed them billions of dollars to do with as they please.
Who is surprised that they have simply accrued greater profits and bid up asset prices?
The financial and economic community will hopefully learn a great many lessons from the global financial crisis. Among the most important is that a failure to act quickly or sufficiently has long-run consequences. The crisis did not need to be this bad, and the failure of central banks and governments across the developed world played a significant role in the human misery that resulted.
Money-financed fiscal policy is not the panacea for every government problem, but in the presence of a liquidity trap and the zero lower bound, it offers an approach that directly tackles the problem of inadequate demand. The same cannot be said for quantitative easing and other unconventional forms of monetary policy, which is precisely why they don’t offer value for money.