This combined with a weak economy and an unresolved financial crisis could in theory lead to a deflationary spiral

TO BE NOTED: From Antonio Fatas and Ilian Mihov on the Global Economy"

"Uncertainty as defined by Larry Summers (or just another example of a two-handed economist?)

In an interview last week, Larry Summers said that "there are risks of both deflation and inflation", so anything is possible... In defense of Larry Summers' lack of commitment when it comes to forecasting inflation, there is indeed an outgoing debate between those who are afraid that advanced economies are heading into deflation and those who believe that the aggressiveness of monetary policy (and the expansion in the central banks' balance sheets) will soon produce a large and persistent increase in inflation rates.

To some this might sound like the standard two-handed approach of economists but I think that in this case the debate is also reflecting an unusual amount of uncertainty as we are dealing with an episode that is different from what we have seen before (of course, as an economist, I have to defend the profession...).

There are two reasons for why uncertainty can be so high. First, this is the deepest recession for many advanced economies after WWII. While there are some historical episodes of even deeper downturns (such as the Great Depression), they took place in a very different economic, political and institutional environment. In addition, some of the monetary policy actions that central banks around the world are taking can be seen as an experiment (out of desperation). Traditional monetary policy actions are not enough so they need to try unorthodox measures. Yes, we have a sense on the consequences that these actions will have but we do not have previous historical experiences to produce a good quantitative estimate. If you want to look at how this uncertainty is reflected in differences in inflation forecasts, here is an interesting entry from the macroblog at the Altlanta Fed on the current state of inflation expectations and uncertainty.

The deflation scenario is one that is supported by the data. Today, the U.S. Bureau of Economic Analysis released the CPI estimate for March and on an annual basis, inflation was -0.4%, the first time this measure is negative since 1955. This combined with a weak economy and an unresolved financial crisis could in theory lead to a deflationary spiral. However, one has to be careful reading too much into the figure that was released today. If one looks at the details, the only category where we had deflation was in "transportation", which is driven by the decrease in oil prices over the last 12 months. Falling oil prices is, if any, good news for the US economy. Other items display inflation rates that were clearly above zero on an annual basis (Food and Beverages at 4.3%, Education at 3.2% and Other Goods and Services at 5.7%). The trend looks somehow more worrisome as on a month to month basis we see negative inflation rates across more categories in some of the most recent months, but it is fair to conclude that we are still far from the type of persistent deflation that can cause major damage to the economy.

The inflation scenario is driven by the massive increase in the balance sheets of many central banks (including the Federal Reserve that has probably been the most aggressive of all). We know that this increase in the balance sheets has not translated into a one-to-one increase in the money supply (see earlier entry about the money multiplier), but there is still the risk of inflation if central banks do not react faster and withdraw the additional liquidity when the economy recovers. Simon Johnson has recently written an article in the Washington Post summarizing the inflationary risks of the current monetary policy "experiment". Theoretically, the Fed has the ability to do what it needs to be done to avoid inflation (see, for example, this article by Woodward and Hall on the potential use of the interest rate paid on reserves).

So what will it be, inflation or deflation? If central banks are good at what they do and they quickly react to the different potential scenarios ahead, we should not see any of the two (i.e. we should see an inflation rate that remains positive but around or below what is considered to be the -explicit or implicit- medium target for central banks).

Under which conditions can central banks fail? On the deflation scenario, the failure would be one of anticipation. As long as central bank are ahead of the curve and provide the necessary liquidity using whatever means are necessary (including the "helicopter money drop"), they should be able to keep their economies from falling into persistent deflation. On the other side (the inflation scenario), there are potentially two risks: a technical one and a political one. From a technical point of view, central banks also need to anticipate changes in inflation expectations and move as fast as they can to avoid any sustained increase in those expectations. The second risk is more of a political nature. One can envision scenarios where the central bank could be under enormous pressure to give up and let inflation increase above its normal level. If the economy recovery is slow but still fast enough to get inflation expectations increasing, undoing the monetary expansion could have a large impact on the interest rate. An increase in the interest rate will impose a serious cost to governments who are currently accumulating debt at a very fast pace because of large deficits. And if growth is not strong enough to bring the necessary tax revenues, governments will feel the need of either raising taxes or cutting spending, none of which are easy from a political point of view. No doubt that this will be an interesting test of the independence of central banks. We have already seen in recent months central banks deciding on actions that "they did not want to take" but it was necessary because of the "special circumstances". If inflation expectations come back too early, the trade off between inflation and growth (and interest rates) will be very strong. Would it also be considered a special circumstance that requires unusual actions by central banks? Let's hope we do not get there and we do not need to test the independence of central bankers.

Antonio Fatás"

This is a huge development, exactly what is required to help restore the animal spirits of global investors.

TO BE NOTED: From The Telegraph:

"Europe fetches the monetary helicopters, at long last

Rejoice. After much pious posturing – and criminal wastage of time – the European Central Bank at last seems ready join the Anglo-Saxons, Japanese, Swiss, and Isrealis in printing money to fend off disaster.

By Ambrose Evans-Pritchard
Last Updated: 7:33PM GMT 26 Mar 2009

Two key governors tipped us off today that the bank is ready to buy assets outright on the open market, including mortgage debt. This is a huge development, exactly what is required to help restore the animal spirits of global investors.

Until now the ECB has offered unlimited liquidity in exchange for collateral from banks. That is not the same thing at all. It is sterilized stimulus. The bank has adamantly refused to cross the Rubicon by scattering money through the economy in real blast of QE. (quantitative easing)

ECB is clearly alarmed by the outright contraction of credit. Loans to non-financial corporations fell in February (minus €4bn).

Yes, the M3 money supply is still up 5.9pc year-on-year, but that is backward-looking. M3 growth has collapsed. The credit crunch that was not supposed to exist in the eurozone is already well advanced.

The bank's vice-president Lucas Papademos (ex-MIT, a heavy-weight) said: "It may be warranted that the central bank purchases private sector bonds to enhance liquidity. No decision has been taken, but it is a possibility that could improve the markets".

"Potential measures could include an extension of the maturity of the central bank liquidity provided to banks and purchases of private debt securities in the secondary market".

Hallelujah.

Nout Wellink, governor of the Dutch central bank, in turn said there is now "an increasing risk of deflation".

Thank you Mr Wellink.

ECB president Jean-Claude Trichet has been insisting for month after month that there is no risk whatsover of deflation. At least a million workers are going to lose their jobs over coming months unneccesarily because of this blind refusal to face the reality of what is happening in the world.

(Or perhaps that is unfair to Mr Trichet's boss – Bundesbank chief Axel Weber. One suspects that Mr Weber does indeed understand what is happening but knows that once the ECB starts buying bonds, it is on the slippery slope to an EU debt union – at German expense. The pressure to bail out Club Med governments may become unstoppable. He is right about that.)

Mr Wellink went on to admit that the ECB had screwed up royally by raising rates last July in response to a phoney inflation scare (oil futures speculation) at a time when much of the eurozone was already in recession.

"In hindsight, this measure was based on a faulty estimate of inflationary risks and real growth prospects."

Bravo, Mr Wellink. This is the first time – to my knowledge – that any ECB governor has admitted any fault in what must be described as the most remarkable act of monetary primitivism in modern times, or indeed admitted any error on anything. One was beginning to think they were incapable of self-criticism.

Thank goodness for Dutch honesty. The ECB will be much stronger for it. Chippy central banks do not command respect.

It has taken a long time to get here: a lot of damage has been done. A German contraction of 6pc to 7pc (Commerzbank forecast) is already baked into the pie this year. German unemployment may reach 5m in 2010 (RWI Institute).

Ireland's GDP has already dropped 7.5pc (year-on-year to Q4). Eurozone Industrial output fell 17.3pc in January (y/y). It was down 31pc in Spain. This is a greater fall than anything suffered in Spain over a 12-month period during the 1930s.

Sadly I have little confidence that the ECB will undertake QE with adequate dispatch, but at least they seem willing to swallow their pride and start to do their part to mitigate the global depression that we are already in.

If they move fast enough they may even prevent the eurozone breaking. Big if."

a clear message that the threat of deflation is being taken seriously

From Mother Jones:

"Helicopter Ben

— By Kevin Drum | Wed March 18, 2009 7:58 PM PST

Ben Bernanke has long said that even with interest rates near zero, the Fed still has plenty of monetary ammunition left to stimulate the economy. Today he put his money where his mouth is and announced that the Fed would be buying up a trillion bucks worth of treasury bills and mortgage securities. This is known as quantitative easing, aka printing money. The Wall Street Journal rounds up some reaction:

Guy LeBas of Janney Montgomery Scott provides the basics: "Even today’s announcement that the Federal Reserve plans on purchasing everything in America that isn’t nailed down raised relatively few eyebrows on our end....Effectively, the Fed is monetizing the Treasury’s debt, a strategy that appears in the encyclopedia under the heading 'how to trigger inflation.' "

David Greenlaw of Morgan Stanley says the purchase of mortgage securities is designed to drive down interest rates: "In 2008, the average mortgage rate on the outstanding stock of loans was about 6.50%. So, if the Fed brings 30-yr fixed rate mortgages down to 4.50% and all homeowners are able refi, the aggregate permanent cash flow savings would be on the order of $200 billion per year."

Paul Dales of Capital Economics isn't sure that $300 billion of Treasury purchases is enough: "This could just be the opening salvo....Overall, no one knows whether these measures will work. Much depends on whether banks loan out the cash they raise from selling Treasuries and whether households and businesses spend, rather than save, any extra borrowing....At the least, no one can say that the Fed isn’t trying."

So there you have it. $300 billion in new money, another $200 billion over time from lower mortgage rates, and a clear message that the threat of deflation is being taken seriously.

That's what the adults were up to, anyway. Back in make believe land, meanwhile, it was AIG bonus time 24/7. Gotta keep Congress busy with something, I guess."

Me:

Helicopter Money

Submitted by Don the libertarian Democrat (not verified) on March 18, 2009 - 8:42pm.

I've been for this. I sure hope it works. It's risky. If it doesn't work, I'm not going to make any excuses. I preferred Buiter's plan, but this should help.

the current mix of stimulus, tax cuts, entitlement spending and falling tax receipts due to lower incomes is more or less equivalent

From The Curious Capitalist:

"Helicopter Ben finally hauls out the helicopter

Posted by Justin Fox | Comments (1) | Permalink | Trackbacks (0) | Email This

The Federal Open Market Committee, that group whose interest rate decisions we used to care about back before the Federal funds rate settled down around 0.15%, moved markets this afternoon with its announcement that it was going to buy lots more mortgage securities (up to $750 billion more) and start buying long-term Treasuries (up to $300 billion worth) for the first time in a very long time.

It was a somewhat surprising announcement, given that the Fed has so far purchased only $69 billion of the $500 billion in Fannie Mae, Freddie Mac and Ginnie Mae mortgage securities it had already committed to buying, and Fed chairman Ben Bernanke had been giving hints that he wasn't quite ready to start buying Treasuries yet. Stock and bond markets initially took it as good news—a sign that the Fed still can do a lot to keep lending going to ease the recession.

But the stock market rally didn't last long, and it probably shouldn't have, because the Fed's move into the long-term Treasury market is a momentous and somewhat unsettling one. As the federal government issues trillions in new debt to finance stimulus spending and the daily operations of government, the quasi-governmental Fed will now be buying hundreds of billions of it, in the process creating new money out of thin air (the Fed doesn't actually have money set aside to buy stuff; when it buys something, the money suddenly, magically exists).

It's a very weird, somewhat circular transaction, and it was last done in a big way during World War II. At the time the Fed wasn't so much making monetary policy as doing its patriotic bit to finance the war (it was a de facto division of the Treasury Department at the time), but it worked on both counts: The deflationary tendencies of the 1930s were finally fully expunged from the economy, and we beat the bad guys. Later on, Milton Friedman described this kind of transaction as the functional equivalent of a "helicopter drop" of money, and after Ben Bernanke mentioned this in a speech in 2002 he became known as Helicopter Ben. Now he's finally living up to the name.*

Will it work? In the sense of fending off deflation, yeah, this should have an impact. But the financial world and America's position in it are more complicated than in the 1940s. We now owe lots of money to creditors outside the U.S., and when they see the Fed buying long-dated Treasuries they're bound to start worrying about what that means for the dollar. If they get too worried, they could drive up interest rates here and counter the impact of the Fed's purchases. So there are limits to the Fed's magical powers, and they already began showing up in currency markets this afternoon, with the dollar falling sharply against the euro and other foreign currencies. The adventure continues.

* Both Friedman and Bernanke were talking about a tax cut financed by Fed purchases of long-term Treasuries, but it seems to me that the current mix of stimulus, tax cuts, entitlement spending and falling tax receipts due to lower incomes is more or less equivalent."

Me:

1. donthelibertariandemocrat Says:
   Wednesday, March 18, 2009 at 6:11 pm

   "* Both Friedman and Bernanke were talking about a tax cut financed by Fed purchases of long-term Treasuries, but it seems to me that the current mix of stimulus, tax cuts, entitlement spending and falling tax receipts due to lower incomes is more or less equivalent."

   I agree, and approve, though, truly, it is risky. In a way, it's a version of Nick Rowe's plan, which I accept if we have to purchase TAs:

   http://worthwhile.typepad.com/worthwhile_canadian_initi/2008/12/central-banks-should-bet-on-recovery-literally.html

   My favorite plan is this:

   Read W.Buiter "Helicopter Money" here:

   http://www.nber.org/~wbuiter/helijpe.pdf

"Their mission is to provide liquidity to the system by acting as lender-of-last-resort "

Casey Mulligan:

"Flight to Quality( FLIGHT TO SAFETY ) -- Cause or Effect?

Professor Lucas is a strong advocate.

I agree that there is a flight to quality( I AGREE ). Professor Lucas says that one way that people attempt to buy safe securities is to spend less on consumption goods. That makes sense -- but the same logic implies that people should work harder (earn more) as another means to accumulate those securities. The facts show that people are working less.( WHY ? COULDN'T IT HAVE TO DO WITH EMPLOYERS CUTTING BACK? ) Barro and King (1984) explained it best -- the basic puzzle of recessions (this one included) is that consumption and leisure move in opposite directions. Wealth effect and intertemporal substitution effect explanations of recessions (Professor Lucas' story is one example) imply that they move together.

That's why I believe that the "flight to quality" is a symptom( HERE I AGREE ) rather than a cause.

Professor Lucas arrives at the conclusion that the Fed should print money. Despite the arguments above, I agree that such a Fed policy would do more help than harm( I AGREE )."

Now Lucas in the WSJ:

"The Federal Reserve's lowering of interest rates last Tuesday was welcome ( TRUE ), but it was also received with skepticism( THAT'S FINE ). Once the federal-funds rate is reduced to zero, or near zero, doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.

It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused( TRUE ). Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending( TRUE ).

There should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector, using them to discount -- lend against -- a wide variety of securities held by a variety of financial institutions. (The addition is to be weighed against September 2007's total outstanding level of reserves of about $50 billion.)

This action has been the boldest exercise of the Fed's lender-of-last-resort function( I AGREE THAT THIS IS WHAT IT IS ) in the history of the Federal Reserve System. Mr. Bernanke said that he is prepared to continue or expand this discounting activity as long as the situation dictates( I AGREE WITH HIM ).

Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a "flight to quality"( FLIGHT TO SAFETY ) that is very much analogous to the "flight to currency"( I AGREE. IT'S LIKE A BANK RUN. HOWEVER, I SEE IT AS A FLIGHT TO EXPLICIT GUARANTEES FROM IMPLICIT GUARANTEES ) that crippled the economy in the 1930s. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety( TRUE. IT'S BOTH. ). Individuals have tried to do this by selling other securities, but without an increase in the supply of "quality" securities these attempts do nothing but drive down the prices of other assets( TRUE ). The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession( TRUE ). Adding directly to reserves -- the ultimate liquid, safe asset -- adds to supply of "quality" and relieves the perceived need to reduce spending( TRUE. STILL THE FLIGHT TO SAFETY ).

When the Fed wants to stimulate spending in normal times, it uses reserves to buy Treasury bills in the federal-funds market, reducing the funds' rate. But as the rate nears zero, Treasury bills become equivalent to cash, and such open-market operations have no more effect than trading a $20 bill for two $10s. There is no effect on the total supply of "quality" assets.

A dead end? Not at all. The Fed can satisfy the demand for quality by using reserves -- or "printing money" ( GO FOR IT )-- to buy securities other than Treasury bills. This is the way the $600 billion got out into the private sector.

This expansion of Fed lending has not violated the constraint that "the" interest rate cannot be less than zero, nor will it do so in the future. There are thousands of different interest rates out there and the yield differences among them have grown dramatically in recent months. The yield on short-term governments is now about the same as the yield on cash: zero. But the spreads between governments and privately-issued bonds are large at all maturities. The flight to quality means exactly that many are eager to trade private paper for non-interest bearing (or low-interest bearing) reserves and with the Fed's help they are doing so every day( TRUE, ALTHOUGH IT SOUNDS FOOLISH ).

Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this( WE DO CARE ). We care about the quantity of its liabilities( OK ).

There are many ways to stimulate spending, and many of these methods are now under serious consideration. How could it be otherwise? But monetary policy as Mr. Bernanke implements it has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans.( I'D PREFER SIMPLY PUTTING MONEY OUT AND LEAVING IT )It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues( THAT'S A GOOD POINT )."

More or less, I agree.

"The bottom line is that Bernanke has made a gamble with something approaching 2 trillion."

James Hamilton on Econbrowser:

"Federal Reserve balance sheet

Here I survey how we got here, where things currently stand, and what it all means.

Let me begin by reviewing some first principles of what the Fed is all about. How did the cash currently in your wallet get there? You withdrew it from an ATM, perhaps. But these wonderful contraptions don't just give you the green stuff for free-- you had to have deposits in the bank to be able to withdraw the cash. You can think of your account with your bank as credits you can use to get cash whenever you want it.

But where did your bank get the cash? It likely has an account with the Federal Reserve System, which account, just like the one you have with your bank, shows a certain level of deposits that the bank has in its account with the Fed. Your bank can then go to the Fed and withdraw those deposits in the form of cash. So you can think of your bank's deposits with the Fed as credits it can use to get cash whenever it wants.

And how did your bank come to have those deposits with the Fed? These deposits are something the Fed has the power to create out of thin air. This indeed is its primary power-- the ability to create money( TRUE ). That's a power that could be easily abused, so our system is set up to prevent the Fed from creating deposits willy-nilly. Specifically, the traditional operation of the Federal Reserve was to purchase assets such as Treasury securities from a private dealer, paying for them by simply crediting the dealer's account with the Fed with new deposits. The Fed hasn't created any wealth with this transaction, it has simply introduced a new asset (ultimately, money) and retired an old (the Treasuries that were formerly held by a member of the public are now held by the Fed). ( OK )

Although private sector wealth is unchanged as a result of this transaction, there is one important implication for the Treasury. Before the Fed made this open-market purchase, the Treasury was obligated to pay interest on those securities to someone in the private sector. Now as a result of the open-market purchase, the Treasury is making that payment to the Fed. The Fed in turn returns those payments back to the Treasury. You can see those payments from the Fed back to the Treasury each month in Table 4 of the Monthly Treasury Statement( GO TO FMS LINK ).

But wouldn't the Treasury want the Fed to simply buy up all of its outstanding debt, and relieve the taxpayers forever of that nasty burden? It might, but to do so would require so much new money creation that it would cause a horrific inflation. To avoid that, we have a careful separation of powers, asking the Fed to take responsibility for inflation and letting the Treasury worry about how to pay its bills.

The Fed could always use its power to acquire assets other than Treasury securities. For example, the Fed could make a loan to a private bank through its discount window. The bank receives the loan in the form of new deposits with the Fed, which again the Fed simply creates out of thin air. The receiving bank presumably used those deposits to pay somebody else, but that transaction simply transferred the Fed deposits to another bank, so that newly created deposits stay in the system until they are withdrawn as cash. The Fed in this case acquired an asset (the loan) whose value by definition exactly equaled that of the newly created deposits( OK ).

Alternatively, the Fed might want to add reserves to the banking system temporarily, to satisfy what it saw as a temporary liquidity need. Traditionally it would do so with a repurchase operation, in which the Fed temporarily takes ownership of an asset held by a dealer, and temporarily credits the reserves of the dealer in exchange. Essentially a repo is a collateralized short-term loan from the Fed to someone in the private sector.

There are some other categories of assets the Fed could acquire, and some other potential disposition of reserves it creates on the liabilities side. The chief among the latter that I will mention here is the Treasury's account with the Federal Reserve. This traditionally was used by the Treasury for cash management of its receipts and expenditures. Some of the deposits that the Fed creates (for example, with a discount window loan) might have ended up being transferred between banks (as individual customers send checks to customers of other banks) and ultimately end up in the Treasury's account (as income taxes get withheld, for example). Since the Treasury isn't going to withdraw these funds as cash, they're counted separately on the liabilities side of the Fed's balance sheet.

There are a lot of other little categories we could discuss, but historically there was really just one big story-- the Fed created deposits primarily by buying Treasury securities, and these ultimately ended up as cash held by the public( OK ). The left column of the table below summarizes the assets (factors supplying reserves) and liabilities (factors absorbing reserves) as of December 5, 2007. At that time, 85% of the Fed's assets were held in the form of Treasury securities, and 89% of its liabilities took the form of currency held by the non-bank public.

Balance sheet of the Federal Reserve.
(Based on end-of-week values, in billions of dollars). Data source: Federal Reserve Release H.4.1.

	Dec 5, 2007	Dec 17, 2008
Securities	779.7	493.8
Repos	46.5	80.0
Loans	2.1	1039.9
Other	92.0	733.0
Factors supplying reserve funds	920.4	2346.7
Currency in circulation	819.3	877.7
Reverse repos	36.7	71.9
Treasury accounts	5.1	484.6
Service and reserve balances	16.0	801.8
Other	43.4	110.7
Factors absorbing reserve funds	920.4	2346.7
Off balance sheet
Securities lent to dealers	4.5	186.5

Over the last year, however, there were some profound changes in the composition of the Fed's balance sheet. These initially were dictated by the desire of the Fed to make more loans (which it thought it needed to do to alleviate problems in the credit market) without creating any new money (which it worried would create inflation). The way the Fed sought to achieve this was by selling off a large chunk of its holdings of Treasury securities, and replacing them with loans and alternative assets. These came in a variety of shapes and colors, but the two biggest categories at the moment are the Term Auction Facility, which essentially is a systematic program to encourage a particular volume of borrowing by banks from the Federal Reserve, and amounted to $448 billion as of last week, and currency swap lines, the biggest factor in the "other" asset category reported on the Fed's H.4.1, said other category coming to some $682.4 billion last week. Up until September of this year, the Fed was implementing these changes without increasing the total level of assets on its balance sheet. The graph below plots the composition of the end-of-week asset holdings of the Federal Reserve over the last two years.

Federal Reserve assets in billions of dollars. Data source: Federal Reserve Release H.4.1..

Beginning in September, the Fed decided it couldn't afford to sell off any more of its Treasuries, but wanted to lend more and still have no effect on the money supply. To do so it needed to find a way to funnel the reserves created by the new loans it would make into categories on the liabilities side that would not result in more cash held by the public. The first such device was to reach an agreement with the Treasury for the Treasury to simply hold on to a huge volume of Federal Reserve deposits, some $484.6 billion as of last week. The way this worked is that two operations were implemented simultaneously. First, the Fed created a lot of new deposits, for example, $318.8 billion from the Commercial Paper Lending Facility alone. Second, the Treasury borrowed an additional half trillion from the public, forcing somebody in the public to send a check to the Treasury. In the aggregate, the reserves created by the Fed through the CPLF end up just being parked in the Treasury's account with the Fed, with no creation of money. The graph below plots the composition of the liabilities side of the Fed's balance sheet over the last year. By definition, the height of the line in the graph below is identical for every date to the height of the line in the graph above.

Federal Reserve liabilities in billions of dollars. Data source: Federal Reserve Release H.4.1..

The second measure that the Fed employed to allow this ballooning of its assets was to start paying banks an interest rate on reserves that is exactly equal to its target for the fed funds rate itself, essentially eliminating any incentive for the banks to lend fed funds and encouraging banks instead to simply let excess reserves accumulate. Last week, banks were sitting on about $800 billion in excess reserves with the Fed, doing absolutely nothing with them. The Fed was in effect lending those funds in place of the banks. I have been quite apprehensive about this scheme( I THOUGHT IT WAS AN INCENTIVE TO HOARD, AND NOT LOAN IN THE CURRENT SITUATION ), particularly now that we have reached a point where, in my opinion, the Fed in fact does want the money supply to increase so as to cause a little inflation. But the present arrangement makes it quite awkward for the Fed to do so( YEP ).

And what's the risk associated with the Fed's new strategy? Back when the Fed held $800 billion in Treasuries, these were a liability of the Treasury and an asset of the Fed. In effect, the Treasury's nominal obligation was one for which taxpayers would never owe a dime. Now that more than half of those securities have been lent or sold off by the Fed, and the Treasury has borrowed a half-trillion extra to make this work, that's more than a trillion extra for which the taxpayers are potentially on the line( OK ). If the loans and other assets that the Fed has acquired with those funds do not make a loss, then all is still well and good. But if the Fed's new loans do not perform, there won't be a positive receipt in the Monthly Treasury Statement corresponding to interest returned from the Fed to the Treasury. In other words, the federal deficit will rise by the amount of the extra interest the Treasury owes on up to a trillion dollars in new debt( THAT'S THE RISK ).

And how about the Fed's "free money" from the ballooning excess reserves? If those funds do start to end up as cash held by the public, then the Fed will need to worry again about inflation, in which case it has two options. One is to sell off some of its remaining assets (or fail to roll over some loans). In this case, the consequences for the Treasury are the same as above-- that income from the Fed's earnings is no longer coming back to the Treasury, and it's as if the $800 billion in excess reserves was again replaced by direct Treasury borrowing.

The second option is just allow the inflation.

The bottom line is that Bernanke has made a gamble with something approaching 2 trillion. If the gamble wins, taxpayers owe nothing. If the gamble loses, taxpayers are committed to borrow a sum equal to any losses and start making interest payments on it( THAT'S IT ).

For the record, let me reiterate my personal position on all this.

(1) I am doubtful of the Fed's ability to alter interest rate spreads through the kinds of compositional changes in its balance sheet implemented over the last two years. Whatever your prior ideas were about this, surely it's time to revise those in light of incoming data-- if the first trillion dollars didn't do the job, how much do you think it would take to accomplish the task? ( NOT SURE )

(2) I think the Fed's goal should be a 3% inflation rate( THAT'S REASONABLE ). Paying interest on reserves and encouraging banks to hoard them is inconsistent with that objective, as would be a new trillion dollars in money creation. ( ON THE FIRST POINT I AGREE. ON THE SECOND, WHAT WOULD THE INFLATION RATE BE ? )

I would therefore urge the Fed to eliminate the payment of interest on reserves( I AGREE ) and begin the process of replacing the exotic colors in the first graph above with holdings such as inflation-indexed Treasury securities and the short-term government debt of our major trading partners( WHICH PAY INTEREST ).

I think that this is a sensible moderate proposal, which would be great if it works. I simply believe that it might not work in creating inflation, but I hope that it does. I still think that we need to print money.

OK. Nick Rowe turned up in the comments with a more serious explanation of my concern:

"Let's compare the Fed's "gamble" with helicopter money.

With a "helicopter" increase in the money supply, the Fed's balance sheet shows a new liability, and no new asset( TRUE. THEY SIMPLY PRINTED MONEY AND GAVE IT AWAY ).

That is equivalent to the Fed buying an asset, with newly-printed money, and then the asset turning out to be worthless( TRUE ).

In other words, if you believe that a "helicopter" increase in the money supply is what is needed to get the economy out of a liquidity trap, then the destruction of the Fed's balance sheet net worth is exactly what the Fed is trying to achieve( YES ).

The only difference between helicopter money and the Fed's buying a worthless asset is in who gets the money: the person who picks it up off the ground (i.e. the one who receives the government transfer payment); or the person who sold the fed the worthless asset.

Let me put it another way: if it lost the gamble, the Fed would be forced to print money to make the same monthly transfer to Treasury, and this would be inflationary. But the expectation of future inflation is exactly what the Fed needs to create now, to escape the liquidity trap. This is a gamble the Fed wants to "lose".( TRUE )

Posted by: Nick Rowe at December 22, 2008 12:25 PM

Now a response from Hamilton:

"Nick Rowe: I agree that an increase in the monetary base is a good idea. I disagree that the appropriate number is a trillion dollars, or that uncertainty about what the number is going to be is a good thing."

Nick Rowe again:

"Uncertainty about the increase in the monetary base *is* a good thing, if the size of the increase in the money base is closely correlated with the amount that is needed, something about which we are equally uncertain.

The value of the Fed's risky assets is correlated with how quickly the economy returns to normal. If the economy returns to normal quickly, those assets will be worth a lot, and so the permanent increase in the money base will be very small. If the economy does not recover, those assets will be worth very little, and the permanent increase in the money base will be very large. And one trillion might not seem excessive in a worst case scenario.

So you have a negative-feedback equilibrating mechanism in place, created by the Fed's buying risky assets, the value of which is correlated with the Fed's success in getting the economy out of a deflationary slump.

It is as if Ben Bernanke made a very large bet, backed by the Fed's printing presses, about the future rate of recovery and inflation.

Posted by: Nick Rowe at December 22, 2008 01:19 PM

Now a question to Nick:

"Nick,

Not sure I understand your point on "helicopter money".

The Fed always has the option of asset backing a helicopter drop.

Why do it by debiting the Fed's capital position deliberately?

Posted by: JKH at December 22, 2008 01:20 PM"

Nick Rowe responds:

"JKH: "Helicopter money" is a *permanent* increase in the supply of money (by assumption), and it adds to private sector wealth, at the existing price level, (because it's just given away). These two features make it the most powerful form of increases in the money supply. Because it's permanent, it increases expected future price levels (which encourages people to spend money now). Because it's just given away, and increases household wealth (at the existing price level), you get a wealth effect on spending, not just the substitution effect (which is very weak or non-existent in a liquidity trap anyhow).

The purpose of "debiting" the Fed's capital position is to create the expectation that the Fed cannot buy back the money, so that it is seen as permanent, and thus more powerful.

Am doing a post on this at WCI now.

Posted by: Nick Rowe at December 22, 2008 02:09 PM"

I am essentially following Nick Rowe's reasoning in this. Thankfully he keeps commenting.

"But desperate times lead to desperate actions by desperate policy makers."

Roubini on ZIRP:

"The Fed decision to cut the Fed Funds range to 0%-0.25% has formalized the fact that, over the last month, the Fed had already moved to a zero-interest-rate policy, or ZIRP, and started a policy of quantitative easing (QE) as its balance sheet has surged over the last few months from $800 billion to over $2 trillion.

The Fed is now undertaking even more unorthodox policy actions. These actions are occurring while the U.S. and the global economy are at risk of a protracted bout of "stag-deflation" (stagnation and deflation).

While it is now fashionable to talk about such deflationary risks (and the latest U.S. Consumer Price Index figures confirm that we are entering into deflation ) some of us were worrying about the coming deflation well before the mainstream--concerned with short-run and unsustainable increases in commodity prices--discovered the deflationary risks in the global economy.

It was clear to those who saw, early on, the risks of a severe U.S. and global recession, that deflationary rather than inflationary pressures would emerge alongside a slack in goods, labor and commodity markets. Welcome to the world of stag-deflation or, as Paul Krugman would put it, the world of "depression economics."

So what is the outlook for 2009? And what is the likely policy response to the risks of a global stag-deflation?

The outlook for the U.S. and the global economy is now very bleak and getting worse as the global economy experiences its worst recession in decades. In the U.S., recession started last December and will last at least 24 months until next December--the longest and deepest U.S. recession since World War II, with the cumulative fall in gross domestic product possibly exceeding 5%.

In comparison, the last two recessions in 1990-91 and 2001 lasted only eight months each and the cumulative fall in GDP was only 1.3% and 0.4%, respectively. There is also a risk that this deep and protracted U-shaped recession (the mainstream consensus view of a V-shaped short and shallow recession is now out the window) may morph into a more severe Japanese style L-shaped recession unless aggressive fiscal policy and recapitalization of the financial system is enacted.

The recession in other advanced economies (the euro zone, the U.K., other European economies, Canada, Japan, Australia and New Zealand) started in the second quarter of this year, before the financial turmoil in September and October further aggravated the global credit crunch. This contraction has become even more severe since then. I don’t expect growth in the advanced economies to recover before the end of 2009.

There is now also the beginning of a hard landing (growth well below potential) in emerging markets as the recession in advanced economies, falling commodity prices and capital flight all take their toll on growth.

Indeed, the world should expect a recession (growth in the -1 to -2% range) in Russia and a near recession (growth close to zero) in Brazil next year, owing to low commodity prices. There will also be a very sharp slowdown in China and India that will be the equivalent of a hard landing for these countries. In China the latest figures for electricity use, exports and imports suggest that the economy is already close to the hard landing scenario of a growth rate of 5%. The deceleration of growth in China is much more rapid than expected.

Other emerging markets in Asia, Africa, Latin America and Europe will not fare better and some may experience full-fledged financial crises. More than a dozen emerging-market economies now face severe financial pressures: Belarus, Bulgaria, Estonia, Hungary, Latvia, Lithuania, Romania, Turkey and Ukraine in Europe; Indonesia, South Korea and Pakistan in Asia; and Argentina, Venezuela and Ecuador (a country that has just defaulted on its sovereign debt) in Latin America.

What is the policy response in the U.S. and other countries to this risk of a global stag-deflation?

The Fed decision to cut the target for the Fed Funds rate to the 0% to 0.25% range is just underwriting what was already obvious and happening in reality: While the target Fed Funds was until Tuesday still 1%, in the last few weeks--following the massive increase in liquidity by the Fed--the actual Fed Funds was already trading at a level literally close to 0%.

So the Fed just formalized what had already been happening for weeks now, i.e., that the Fed Funds rate was already zero and that the Fed had already moved to quantitative and qualitative easing (QE) in the form of a massive increase in the monetary base and aggressive use of monetary policy to reduce short-term and long-term market rates that are stubbornly high in a sign that the credit crunch is severe and worsening.

I predicted early in 2008 that the Fed Funds rate "would be closer to 0% than to 1%" in the midst of a severe recession. Now, 12 months into this severe recession--a recession that will last at least another 12 months (if not, as is possible, much longer)--the Fed Funds rate is already down to 0% (the beginning of the zero-interest-rate-policy, or ZIRP, for the U.S.) and the Fed has moved into uncharted unorthodox monetary policy as a severe stag-deflation is taking place.

And, as predicted by me over a month ago, the Fed is now committed to keep the Fed Funds rate close to zero for a long time (as a way to push lower long term Treasury yields); purchasing agency debt and agency MBS in massive amounts; and even considering purchasing long-term Treasuries as a way to push lower long-term government bond yields that are already falling sharply.

More aggressive policy actions may be undertaken by the Fed as a severe credit crunch shows no signs of relenting. In a 2002 speech on deflation, Ben Bernanke spoke even of helicopter drops of money, monetizing fiscal deficits and even buying equities.

The latter actions have already been partially undertaken: The Fed is effectively already monetizing U.S. fiscal deficits as the purchase of markets assets is financed with the Fed printing presses rather than the TARP program. And now, with the Fed considering the purchase of long-term Treasuries, such monetization of deficits will be made more formal.

Also, since the TARP has been turned into a program to recapitalize financial institutions (and thus boost their capital and market value), the U.S. has already effectively intervened indirectly in the equity market (by partially nationalizing a good part of the financial system). Once the Fed starts to buy the long-term Treasuries financing the TARP program, this indirect Fed purchase of U.S. equities will be even clearer.

While Fed actions to reduce mortgage rates--via purchases of agency debt and agency MBS--are partially successful as long-term mortgage rates are falling, most of the Fed purchases of private assets have been so far limited to very high-grade securities.

Thus, the gap between the yield on high-grade commercial paper purchased by the Fed and the one that the Fed is not purchasing is sharply rising; ditto for the gap between agency MBS and private label MBS. Also, while long-term Treasury yields are sharply falling, the spread of corporate bonds--both high-yield and high-grade--relative to Treasuries remains huge as a sign of a severe credit crunch.

Thus, as a next step, the Fed may be soon forced to walk down the credit curve and start buying private short-term and long-term securities with lower credit ratings. That would mean the Fed will take on even more credit risk than it is already taking on today while purchasing illiquid private assets. But desperate times lead to desperate actions by desperate policy makers."

This post seemed to be simply a list of what's happening. Not much to disagree with. As for the predictions, I've no idea.

"As for me, I think dropping money out of a helicopter is looking better and better"

Greg Mankiw with a good post:

Let the Rent Seeking Begin ( HOW CAN IT STOP. THAT'S OUR SYSTEM. AND, HERE'S THE RUB, OUR INVESTMENT CLASS LOVES IT )


The Institutional Economics blog points to this story:

The Association of Zoos and Aquariums (AZA) today called for shovel-ready zoo and aquarium infrastructure projects to be eligible for Federal stimulus funding....Many zoos have their roots in the Great Depression, when the Federal Work Projects Administration (WPA) helped build many zoos across America. ( I DON'T LIKE ZOOS, BUT I UNDERSTAND WHY PEOPLE DO )

Of course, this lobbying is part of the political process ( UNDERSTATEMENT ). Whether the AZA gets the money it wants for new zoos will be up to the new administration and Congress. I am sure that the Obama transition team is now carefully evaluating many hundreds of billions of dollars of proposed spending projects and will, over the next few weeks, determine precisely which of these pass a cost-benefit test ( YES PLEASE ).

As for me, I think dropping money out of a helicopter is looking better and better( CARE TO JOIN THE HELICOPTER CLUB? ). (Or, more seriously, consider my federalist fiscal stimulus.)"

I prefer a Sales Tax Decrease or Payroll Tax Decrease.

"When fighting a slump concentrate on demand and output."

An interesting post on the FT by Samuel Brittan:

"Lessons from the original New Deal

By Samuel Brittan

Published: December 18 2008 18:36 | Last updated: December 18 2008 18:36

President-elect Barack Obama is reported to have responded to the Fed’s brave new anti-depression manifesto by saying that the Fed might soon be running out of ammunition. This need not be so if the new administration co-operates in the last resort course of financing some of the budget deficit by money creation ( YES. THE HELICOPTER CLUB ). It is in any case clear that the incoming president intends to supplement monetary stimulation by greatly increased public sector activity. The hints to this effect immediately made historically conscious observers look back to President Franklin Delano Roosevelt’s New Deal of the 1930s as a prototype.

I hope that Mr Obama and his advisers will copy its better rather than worse aspects. But although, if one is not too partisan, one can extract a common element in analyses of the Great Depression there is still very little consensus about the New Deal, which attempted to tackle it. There are still many Republicans for whom it is a socialist conspiracy and many Democrats for whom it is an article of faith. The academic world is just as split. A majority of political historians give a favourable verdict, while a majority of economists are more doubtful. The one matter of agreement is that Roosevelt was a master politician who won four presidential elections in a row.

The starting point has to be the fact that Roosevelt was no kind of theorist, but embarked on a series of sometimes contradictory improvisations ( TRUE ). There is not even agreement on which of the policies of the 1930s were or were not part of the New Deal. For instance, the insurance of bank deposits was part of the Congress-initiated Glass-Steagal Banking Act of 1933 and made permanent in a subsequent 1935 act. It is this one measure more than any other that was said to have made the US depression-proof (although not of course recession proof). Yet Roosevelt himself accepted the measure only reluctantly because, in the words of Professor Eric Rauchway, he feared that “the government would one day find itself forced to pay out too large a sum for failed banks”( HE WAS RIGHT, BUT IT WAS STILL A GOOD IDEA ) (The Great Depression and New Deal: A Very Short Introduction, OUP).

This illustrates the president’s instinctive opposition to budget deficits, although he came at times to accept them as a regrettable necessity( VERY TRUE. HE WAS FAIRLY CONSERVATIVE, BUT PRAGMATIC ).

The New Deal can be divided into three overlapping phases. The first ( 1ST ) heroic phase began when Roosevelt took office on March 4 1933. He began with a six-day enforced banking holiday followed by an emergency act that gave federal authorities increased power over the banking system. He himself then embraced the view that he was saving capitalism rather than destroying it ( HE WAS ). The emergency act also cut the dollar’s link with gold, which was then repegged at a lower rate ( GOOD IDEA ).

This de facto devaluation, together with a subsequent inflow of gold from Europe, facilitated a recovery in the money supply from its catastrophic fall in 1930-32 to resume a more expansionary if erratic course.

These monetary measures were accompanied by a whole alphabet of new agencies to promote employment and relieve distress. Whatever free market rhetoric might assert, I cannot find it in me to condemn Roosevelt for attempting to accelerate job creation more quickly than monetary policy could do on its own at a time when unemployment was near 25 per cent and the best known popular song ran: “Buddy can you spare a dime.” ( I AGREE ENTIRELY )

The first phase gradually gave way to a second ( 2ND ). The more enthusiastic New Dealers were not content with economic recovery and wanted to construct a new economic system, which was not so much socialism as corporatism ( THEY DID THAT ), that is a system in which market forces were replaced as far as possible in the determination of prices by political negotiation between unions and employers’ bodies. Under the National Recovery Act enforceable codes could be issued to do just that – until the NRA was declared unconstitutional by the Supreme Court in 1935. The fight over these measures prompted a more radical phase in the president’s rhetoric in 1936 when he welcomed the hatred of “malefactors of great wealth”.

There followed a third phase ( 3RD ) as the second world war approached in which the New Deal ran out of steam. There was a lurch into financial conservatism in 1937-38 when the administration cut social spending in a renewed attempt to balance the budget and the Fed tightened policy prematurely.

Taking the New Deal period as a whole, the expansion in demand was accompanied by a much larger rise in wholesale prices and a correspondingly lower recovery in output and employment than on previous occasions. Indeed unemployment did not regain its 1929 low until 1943, well into the second world war. Milton Friedman attributes this disappointing experience at least in part to deliberate measures to raise prices and wages by encouraging unionisation. John Maynard Keynes himself gently and wittily reproached the president for unnecessarily antagonising business.

I would draw a simple moral. When fighting a slump concentrate on demand and output ( FINE ). Do not interfere with prices and wages ( YES ); and above all avoid doing anything that wittingly or unwittingly strengthens business, labour or agricultural lobbies ( FINE )."

"Toyota was receiving subsidies worth $300m to build its Mississippi plant"

Another Helicopter post. From Richard Adams in the Guardian:

"The worst piece of economic news coming out of the US in the last week wasn't yesterday's move by the Federal Reserve to cut its fed funds interest rate to a Depression-era floor of zero. True, the fact that official interest rates are hovering around 0% is eye-catching, but the move was more symbolism than anything else – since some US Treasuries are already being traded at close to zero interest. In other words, the Fed's cut was merely a reflection of reality.

(And in case anyone in the UK or Europe was feeling smug about this event, don't worry – the Bank of England and the European Central Bank will be joining the "zero club" soon enough in 2009.) ( TRUE )

And no, the worst piece of economic news wasn't even the more significant discovery that US consumer prices fell by 1.7% last month, given that it raises the spectre of deflation, a dangerous spiral of falling prices and consumers sitting on their hands, asking why they should buy now when things will be cheaper next month? ( WON'T HAPPEN )

No, potentially the worst piece of news passed by almost without notice: the decision by the Japanese carmaker Toyota to hit the brakes on its construction of a new factory in Mississippi. That decision wrapped up the past and future prospects for the US into one unhappy package. If Toyota cancels its plant, the US economy won't collapse, of course. But it is more than just a bad omen. It's a warning of what is to come for the Federal Reserve and the incoming Obama administration.

Toyota's new car plant wasn't just any assembly line. It was to be the first US factory to make the famous Prius hybrid. Toyota had already invested $300m in it – but it may prefer to kiss that money goodbye than commit the extra $1bn needed to open it. That's a vote of no-confidence in the US economy for starters. More importantly, the Prius was to the 2000s economic bubble what the Aeron chair was to the dotcom boom. For the last couple of years it has been impossible to buy a new Prius off a dealer's lot – the waiting list was too long. Then the sharp spike in the price of oil this year gave another reason to buy the fuel-efficient Prius. Hence Toyota's decision to build a plant in Mississippi. ( MIGHT IT HAVE SOMETHING TO DO WITH THE FALLING PRICE OF OIL, AND THE STRENGTH OF THE YEN? )

But let's not forget that the major economic story of the last couple of weeks – before Bernard Madoff made the front pages – was the begging by Detroit's Big Three carmakers for a government bail-out.

Opponents of the bail-out made much of Detroit's inability to compete with the Japanese manufacturers such as Toyota (a situation largely the result of Congress's decision to restrict car imports from Japan in the 1980s, but that's another matter)( BUT A GOOD POINT. IT LET THE US AUTOMAKERS FEEL FREE NOT TO INNOVATE ), arguing that this would be throwing good money after bad. Most Republicans opposed giving the money to General Motors and Chrysler, including those southern senators who boasted a thriving car industry based on new foreign car factories built in their states. ( PURE POLITICS )

Among the Republicans who shot down the bail-out were Roger Wicker and Thad Cochran, the senators from the great state of Mississippi. But here's the question that could haunt them and their constituents: if the Detroit bail-out had passed, Toyota would have been less likely to have put its Prius factory on ice, and the 2,000 jobs that were to come with it. (Toyota has a choice that GM doesn't have. The Japanese firm can scrap its plans for Mississippi and ship in cars from Japan instead. But that doesn't bring any jobs to Tupelo.)

After all, it's not just sales at Ford and GM that are suffering: in November 2007 Toyota sold more than 16,000 Prius models. Last month it sold just 8,000. The problems of the auto industry are long-term – over-capacity, in the main – but with a short-term kicker: car sales are intimately connected to personal borrowing, since most Americans rely on loans to buy a car (especially new ones). Since the credit crunch has trickled down from Wall Street, it has become harder to get credit to buy a car, since lenders are now more cautious. On top of that, the state of the economy is such that people are delaying a big purchase like a car (or a house) if their income is being squeezed and they decide to pay off earlier debts ( TRUE. I POSTED ABOUT THIS EARLIER ). Even cutting prices may not work ( TRUE, BUT IT WOULD HELP ). The dreaded deflation effects mentioned above may make matters worse. ( INDUBITABLY )

Toyota won't be the only foreign investor changing its plans in the face of a recession. Rebuilding US balance sheets, both commercial and personal, is going to take some time, as businesses and consumers untangle themselves from debt. That task will be made longer and harder if the dinosaurs of Detroit collapse, whether they deserve to or not, or if a new wave of manufacturers such as Toyota are scared away by the toxicity of the economy. (Toyota was receiving subsidies worth $300m to build its Mississippi plant,( FANCY THAT.FREE MARKETS YOU SAY ) in case anyone thinks only Detroit has carmakers who want government funds to help them.)

The woes of Toyota and Mississippi, GM and Detroit, and the fed funds rate hitting zero are all connected. The US economy – along with much of the rest of the so-called developed world – has entered what economists call a "liquidity trap", where holding cash (which earns 0% interest, but is entirely safe) is as good an investment as any other low-risk asset. At that point, central banks may as well just print money to re-inflate their economies – as the FT's Martin Wolf ( DOES EVERYBODY READ WOLF? ) remarked: "As Robert Mugabe has shown, anybody can run a printing press successfully."( I BLOGGED ABOUT THIS POST ) (Certainly, deflation isn't a problem in Zimbabwe.) In that case, why not bail-out Detroit and offer zero-interest loans to the likes of Toyota as well? After all, building eco-friendly, greener cars such as the Prius was part of the Obama economic platform. ( THEY MIGHT WELL DO IT )

The longer-term problems will remain, such as cleaning out the Augean stables( CALL HERAKLES ) of bank balance sheets – and the time has surely come for more radical action in that regard. But in the short term, there's no point in building a new factory if no one is buying cars ( SHARP ).

Milton Friedman once wrote about using helicopters to drop cash on a population and provoke price rises. Time to polish up the rotors and rev the engines. ( IT'S A LOVELY SOUND )

"As I've been boring you rigid with for months and months now, the cause of our economic woes is that we borrowed too much "

Robert Peston on BBC about the choice, if we have one, between Inflation and Deflation:

"The US Federal Reserve and the Bank of England regard the great threat right now as deflation. ( AS DO I )

If they're right, deflation would be a disaster for our economies, for the reason set out in typically elegant fashion this morning by Martin Wolf in the Financial Times. ( ALREADY BLOGGED ABOUT )

As I've been boring you rigid with for months and months now, the cause of our economic woes is that we borrowed too much - or financial institutions lent us too much (to digress for a second: there's a resonant unresolved issue of accountability and responsibility in these two ways of seeing the debt binge). ( DR.JOHNSON BLAMES BOTH THE BORROWER AND LENDER )

The sum of consumer and corporate borrowing in the UK is equivalent to something like 240% of our annual economic output in the UK, while US household and business debt is closer to 300% of that country's GDP. In cash money, that's about $45,000bn - or one of those big numbers that induces vertigo. ( OR INCOMPREHENSION )

Which is quite a burden, and - as far as I can tell - a record-breaking mountain of debt for us to pay off. ( NOT IN TERMS OF PERCENTAGES, I BELIEVE )

The alarming and important point is that if deflation were to set in, if prices were to fall, the real burden of that debt would increase - thus prolonging and exacerbating the severe recessions that appear to be taking hold in both the US and the UK. ( VERY TRUE )

That's why the US Federal Reserve has set its policy interest rate as so close to bupkes or zero as makes no difference. ( OR NIL, NAUGHT, NADA, NOTHING,NULL )

But, of course, the interest rates that businesses and consumers actually pay is much higher. So the Fed has embarked on a mission to bring the interest rates that participants in the real economy pay to as close to zero as it possibly can.

The Fed is doing this by spending hundreds of billions of dollars buying up US government debt and also loans to companies and householders - which has the effect of forcing down yields or interest rates.

By the time the US central bank is finished, it will have pumped trillions of dollars into the US economy in this way.

Over here, the Bank of England is preparing to do something similar, for the moment when its Bank Rate falls to nil (which may never come - but it would be foolish of the Bank of England to assume the zero hour will not arrive).

This process has the ghastly name of "quantitative easing" ( OR PRINTING MONEY, OR DEBASING THE COINAGE ). And it's not dissimilar to running the money printing presses at quadruple speed, filling up choppers with cash and then showering the population with greenbacks. ( THE HELICOPTER CLUB )

It's supposed to encourage ( IT WILL ENCOURAGE THEM. WHETHER THEY DO IT OR NOT IS ANOTHER QUESTION ) businesses and consumers to spend rather than save, so that economic activity revives.

And it exposes the shocking paradox( BRAVO! IT IS A PARADOX! ) of our age: debt got us into this mess, but paying down that debt too quickly will only make the mess worse (or so the Federal Reserve and Bank of England believe - though I should point out that a growing number of economists are beginning to express fears ( WE ALL HAVE THEM ) that what the central banks are doing will prolong and exacerbate the crisis).

What is profoundly unsettling to central banks and governments is that growing numbers of businesses and consumers are opting to save rather than spend even as interest rates fall to these record lows.

Which is why those central banks and governments are taking ever more desperate steps to stimulate growth through increases in public spending and to make money as cheap as possible.

And that of course raises the question ( IS IT A PHILOSOPHICAL QUESTION? ) about whether the worst threat we currently face is deflation or inflation.

At the moment our economies turn, there's a genuine risk( TRUE ) that central banks won't be able to drain all this cheap money from the system quickly enough to avert quite a surge in the inflation rate.

Against that background, I conducted an unscientific poll of leaders of some of our biggest multinational businesses at a lunch( THE BASTARD WOULDN'T EVEN ALLOW US TO HAVE A BLOODY MEAL IN PEACE. HE EVEN POLLED ME IN THE LOO ) a few days ago.

I asked them to think about 2010, and whether they were planning for that to be a year of deflation or inflation.

To a man (this isn't me being sexist, it's that world: they were all men), they said they expected a sharp rise in the inflation rate ( I AGREE. PASS THE CONDIMENTS TRAY PLEASE ).

They said this in a resigned way, as though it was the bill for a party that had been far too expensive and had gone on far too long ( MAYBE THEY'D JUST SEEN THE LUNCH BILL. PESTON HAD SURF AND TURF ).

UPDATE, 09:44 AM:

The Bank of England's monthly agents' survey of business conditions contains disturbing evidence of businesses turning down profitable orders because they're unable to obtain either loans from banks to finance the increase in working capital or insurance from specialist insurers to cover the risk of non payment. ( BLOODY HELL THAT'S DISTURBING )

There's also an alarming trend of businesses conserving cash and deferring or cancelling capital expenditure." ( I'M ALARMED BY THE TIME. NEVER BOTHER ME UNTIL AFTER TEN )

"Unquestionably, yes: used ruthlessly, it will eliminate deflation. But returning to normality thereafter will prove far more elusive."

Martin Wolf in the FT joins the Helicopter Club:

‘Helicopter Ben’ confronts the challenge of a lifetime

By Martin Wolf

Published: December 16 2008 20:01 | Last updated: December 16 2008 20:01

Central banks may soon resort to their most powerful weapons against deflation: the printing press and the “helicopter drop” of money. It is a time for which Ben Bernanke, chairman of the Federal Reserve, has long prepared. Will this weaponry work? Unquestionably, yes: used ruthlessly, it will eliminate deflation. But returning to normality thereafter will prove far more elusive. ( ALL TRUE )

EDITOR’S CHOICE

Economists’ forum - Oct-01

Every week, 50 of the world’s most influential economists discuss Martin Wolf’s articles on FT.com

Mr Bernanke delivered a celebrated speech on the topic in November 2002, when still a governor.* ( I SCANNED IT ON THIS BLOG ) He spoke quite soon after the US stock market bubble burst in 2000. Policymakers then feared the US might soon follow Japan into deflation – sustained declines in the general price level.

Yet Mr Bernanke then insisted “that the chance of significant deflation in the US in the foreseeable future is extremely small”. He pointed to “the strength of our financial system: despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape”. The words “pride” and “fall” come to mind. Six years and a housing-cum-credit bubble later, chairman Bernanke must be sadder and wiser. ( AREN'T WE ALL? )

Mr Bernanke’s view was also that “the best way to get out of trouble is not to get into it in the first place”. The fear that reversing deflationary expectations would prove hard explains why the Fed has cut its official interest rate so quickly since the crisis broke in August 2007.

Is deflation a realistic likelihood? Core measures of inflation strongly suggest not ( TRUE ). But one measure of expected inflation – the gap between yields on conventional and index-linked Treasuries – has collapsed to 14 basis points. Moreover, yields on 10-year US Treasury bonds are already where Japan’s were in 1996, six years after the latter’s crisis began. (See the charts, which start one year before respective asset price peaks.)

Why then should central banks fear deflation? First, deflation makes it impossible for conventional monetary policy to deliver negative real interest rates( I AGREE ). The faster the deflation, the higher real interest rates will be. Second, as explained by the great American economist Irving Fisher in the 1930s, “debt deflation” – the rising real value of debt as prices fall – then becomes a lethal threat. In the US, whose private sector gross debt soared from 118 per cent of gross domestic product in 1978 to 290 per cent in 2008, debt deflation could trigger a downward spiral of mass insolvency, falling demand and further deflation. ( VERY TRUE )

Already, the Fed has adopted a host of unconventional ( RARELY NEEDED ) actions to keep the economy afloat. By December 10 the Federal Reserve’s balance sheet had reached $2,245bn (€1,663bn, £1,490bn), a jump of $124bn over a week and $1,378bn over a year. It held a wide range of government and private paper, including $476bn in Treasury securities, $448bn in “term auction credit”, $312bn in commercial paper and $233bn in “other loans”, which includes $57bn of credit to AIG alone. If it keeps going, the Fed may become the largest bank in the world. ( IT IS. IT HAS THE AMERICAN TAXPAYER BEHIND IT )

Does it face any constraint? Not really ( GOOD ). As Robert Mugabe has shown, anybody can run a printing press successfully ( WHY NOT BRING UP HITLER ? ). Once the interest rate hits zero, the Fed can perform much further easing. Indeed, it can create money without limit ( I HOPE THEY DO ). Imagine what would happen if an alchemist could transform lead into gold, at no cost. Gold would not be worth much. Central banks can create infinite quantities of money, at no cost. So they can reduce its value to nothing without difficulty. Curing deflation is child’s play in a “fiat money” – a man-made money – system ( THIS WAS A BIT OVER THE TOP ).

So what might central banks do? They might lower longer-term interest rates by buying as many long-term government bonds as they wish or by promising to keep short rates low for a lengthy period. They might lend directly to the private sector. Indeed, they might buy any private asset, at any price and in any quantity they choose. They might also buy foreign currency assets. And they might finance the government on any scale they think necessary ( THEY MIGHT. WHAT OF IT? ).

Alternatively, the fiscal authorities can run a deficit of any size they wish and then finance it by issuing short-term paper that the central bank would have to buy, to keep interest rates down. At the zero-rate boundary, fiscal and monetary policies become one ( MERGING THE FED AND TREASURY DEPARTMENT SHOULD SAVE US SOME MONEY ). The central bank’s sole right to make monetary policy is gone. But the reverse is also true: the central bank can send money to every citizen. This is the helicopter drop proposed by the late Milton Friedman and recently discussed by Eric Lonergan on the FT’s economists’ forum ( ALSO DISCUSSED ON THIS BLOG AND AGREED WITH ).

At this point, one might wonder why Japan has struggled with deflation for so long. I have little idea. But the explanation seems to be that the Bank of Japan did not wish to take such drastic measures and the Ministry of Finance did not dare to force the point. Such self-restraint will not deter the US authorities ( NO WAY ).

So will the Federal Reserve drown the world in dollars, whereupon we will be able to wake from the nightmare? As Willem Buiter shows in a recent blog, “Confessions of a Crass Keynesian”, the answer is No. ( VERY TRUE )

Once inflation returns, the central bank will need to sell assets into the market, to mop up the excess money it has created in fighting deflation. Similarly, the government must reduce its deficit to a size it can finance in the market. Otherwise, deflationary expectations may swiftly turn into expectations of above-target inflation. This may also happen if the debt sold in efforts to sterilise the monetary overhang is deemed beyond the government’s ability to service.

Countries without a credible currency may reach this point early. As soon as a central bank hints at “quantitative easing”, flight from the currency may ensue. This is particularly likely when countries remain burdened under a huge overhang of domestic and foreign debt. Creditors know that a burst of inflation would solve many problems in the US and the UK. The US may manage the danger of resurgent inflationary expectations. The UK is likely to find it more difficult. Avoiding deflation is easy; achieving stability thereafter will be far harder ( ABSOLUTELY TRUE ).

Ironically, we are where we are partly because the Fed was so terrified of deflation six years ago. Now, a credit bubble later, Mr Bernanke has to cope with what he then feared, largely because of the Fed’s heroic attempts at prevention. Similar dangers now arise with the drastic measures that look ever more likely. This time, I suspect, the result will ultimately not be deflation but unexpectedly high inflation, though probably many years hence ( THIS IS A REASONABLE FEAR ).

"As I put it, perhaps too glibly, the central bank needed to “credibly promise to be irresponsible.”

Paul Krugman claims to have founded the Helicopter Club:

" A whiff of inflationary grapeshot

Greg Mankiw suggests that the Fed respond to the crisis by committing to substantial inflation over the next decade. Great idea, wish I’d thought of it. Oh, wait …

Actually, Greg has arrived at the same conclusion I did more than a decade ago, when I tried to model the problems then facing Japan, and now facing us. As I pointed out back then, the essence of a liquidity trap is that the real interest rate is too high, even when the nominal rate is zero. So the theoretically “correct” answer, if you can swing it, is to create expected inflation, pushing the real rate down.

As I put it, perhaps too glibly, the central bank needed to “credibly promise to be irresponsible.”

The thing is, at the time my analysis was widely treated as somehow wild and crazy, even though it came straight out of an extremely buttoned-down theoretical model. Japan was supposed to suffer for its sins, not inflate its way out of them. I wonder if similar proposals for the United States will receive the same reception.

Update: I should add that my initial paper led to a fairly extensive literature on the subject of creating inflationary expectations. See, for example, the references here."

What about Helicopter Money?

"All that matters is that both currency and reserves represent ultimate, unquestioned liquidity. And they do."

Willem Buiter on the Fed move:

"The Fed has joined the Bank of Japan at the (near) zero lower bound on the overnight risk-free nominal interest rate; the Federal Funds target rate is set between zero and 25 basis points. The rather strange vagueness of the new target - a 25 basis points range rather than a point target - is unnecessary. It is the product of the inexplicable inability of central banks everywhere (US, UK, Euro Area) to fix the overnight rate at any level (including zero) by accepting deposits (reserves) at that rate in any amount at any time and to lend (against appropriate collateral) at that rate in any amount at any time.

Being willing to buy or sell any amount at a price is the definition of setting a price. Central bankers want to both set the price (overnight interest rate) and keep some control over the quantity (reserves held by banks with the central banks and/or the stock of secured overnight lending). Except for a fluke, they will be frustrated. The overnight rate will, quite unnecessarily, depart from the official policy rate (the Federal Reserve’s Federal Funds target rate, the Bank of England’s Bank Rate, the ECB’s Main refinancing operations Fixed rate). It’s an unnecessary slight operational blemish - a minor badge of operational incompetence.

But this minor deficiency in the genetic code of central bankers and central bank officials charged with setting the overnight rate should not obscure the fact that the Fed’s decision to head straight for the zero lower bound on short nominal interest rates was the right thing ( HEAR HEAR ). At worst it will not help much to bring down the cost of private borrowing and increase its availability. But it won’t hurt.

The Fed and the Bank of Japan will soon have company on the floor. The Bank of England should get Bank Rate to zero late spring or early summer and even the ECB, the ultimate gradualist procrastinator, will get there before the middle of 2009.

Then what? Quantitative easing and qualitative easing are next. Quantitative easing is the expansion of the balance sheet of the central bank keeping constant the liquidity and (credit) risk composition of its assets, by increasing the stock of base money. It does not matter whether the increase in the stock of base money takes the form of an increase in the stock of currency (bank notes) or an increase in the stock of reserves held by the banks with the central bank. Currency does not bear interest, while reserves may bear interest, positive or negative. For ’seigniorage’ the interest paid on base money matters; it is a key determinant of the profits of the central bank, the solvency of the central bank and the payments made by the central bank to the Treasury.

But as long as the solvency of the central bank, its capacity to pursue its its mandate and the solvency of the sovereign are not dependent on a particular level of seigniorage earned by the central bank, the fact that reserves are interest-bearing and currency is not does not matter for the central bank’s ability to use quantitative easing and qualitative easing to bring rates and spreads down. All that matters is that both currency and reserves represent ultimate, unquestioned liquidity. And they do.

Qualitative easing is a change in the composition of the assets on the central bank’s balance sheet towards less liquid and higher risk assets. The Fed has made it clear that it does not have great ambitions for bringing down the long-term risk-free nominal interest rates on US Treasury bonds. These long-term yields are already rather low. Instead its main ambition is to reduce the spreads between official rates and private lending and borrowing rates. It will do so by increasing the amount of private securities held on its balance sheet.

Some of this increase in the share of private sector assets in the Fed’s balance sheet will represent the Fed’s acceptance of a wider range of private securities as collateral in repos, at the discount window and in its steadily growing number of special facilities. Increasing amounts will be the result of outright purchases of private securities by the Fed, something I recommended in August 2007. The Fed has already purchased large quantities of commercial paper and asset-backed commercial paper. It is also increasing its purchases of residential mortgage-backed securities issued by or guaranteed by Fannie and Freddie. It is planning purchases of a wider range of asset-backed securities. It may end up emulating the Hong Kong Monetary Authority by investing in the stock market, say by purchasing a suitable index of listed stocks, like the Wilshire 5000 Total Stock Market Index. I made such a proposal when deflation and the zero lower bound last threatened, in 2003.

One thing the central bank needs in order to engage wholeheartedly in quantitative easing and especially in qualitative easing, is the full backing of the Treasury/ministry of finance. Greater central bank exposure to private sector default risk is an inevitable result of quantitative and qualitative easing, unless the entire expansion of the balance sheet of the central bank is achieved by purchasing sovereign debt instruments. If the default risk materialises, the Treasury has to recapitalise the central bank immediately. Such automatic indemnification is necessary if the central bank is to be able to pursue its regular macroeconomic objectives. If it is not automatic and unconditional, it threatens the operational independence of the central bank in its rate setting decisions.

The need for fiscal backing of the central bank for the central bank to be able, without endangering its price stability objective, to engage in quantitative and qualitative easing by raising its exposure to private securities subject to default risk means that the Euro Area suffers from a handicap. At least 15 national Treasuries (of the 15 Euro Area member states) and possibly as many as 27 national Treasuries (of the 27 EU member states - all 27 EU member states’ national central banks are shareholders of the ECB) may have to be involved in a recapitalisation of the ECB/Eurosystem if it were to suffer a material capital loss as a result of its monetary and liquidity operations.

That would be a huge organisational, logistic, technical and political problem. It can only be solved effectively by creating the beginning of a supranational EU fiscal authority, with independent tax and borrowing powers ( WOW ). The alternative, interim solution, would be to create an EU fund (containing, say, €2.5 trillion or €3 trillion) which could be used to recapitalise the ECB/Eurosystem at short notice.

What else can be done by the central banks?

The spreads between interbank rates (Libor, Euribor) and either Treasury securities of the same maturity or the market’s expectation of the official policy rate over the same horizon (as reflected in the overnight indexed swap (OIS) rate) have been coming in but still appear excessive. In addition, very little interbank lending appears to take place at these interbank rates.

I propose that the Fed, the ECB and the Bank of England set themselves up not just as providers of a clearing platform for interbank lending, but as a market maker or universal counterparty in the unsecured interbank market. The central bank would set, say, 3 month Libor as follows. The central bank would offer to accept deposits from eligible banks at the 3-month OIS rate minus, say, 50 basis points or 75 basis points, and it would be willing to lend unsecured to eligible banks at the 3-month OIS rate plus, say, 50 basis points or 75 basis points. The rates offered for loans could be made to depend on the central bank’s assessment of the borrowing bank’s creditworthiness, with 50 or 75 basis points being the benchmark for a bank with a AA or A rating. The amounts lent at these spreads over Libor would not be open-ended. These facilities would be offered for unsecured loans to and deposits from banks at any maturity between overnight and, say, 2 years. The OIS markets now stretch to a 30-year horizon and are sufficiently liquid to provide useful benchmarks for pricing the corresponding unsecured interbank markets."

All good points, but I agree with Nick Rowe:

"Quantitative and qualitative easing would be more effective if the Fed liabilities were NOT backed by the fiscal capacity of the Treasury. That way an increase in the money supply would be more likely to be seen as permanent, and thus more likely to increase expected inflation.

Helicopter money is theoretically equivalent to buying assets which turn out to be bad (because you are then just giving away money).

In other words, the helicopter would be more effective if the Fed publicly threw away its vacuum cleaner (or at least locked it up for 10 years). Indeed, in a liquidity trap, the helicopter won’t work at all if people expect the vacuum cleaner to be brought into play as soon as there is an excess supply of money.

There is a trade-off between the effectiveness of fighting deflation now and being able to control subsequent inflation if the Fed overdoes it.

Posted by: Nick Rowe | December 17th, 2008 at 3:32 pm | Report this comment"

Here's my, deflation effected, - 2 cents:

I think that Nick is right. I believe that everyone should read this paper:

http://www.nber.org/~wbuiter/helijpe.pdf

I actually thought that you agreed with Nick.

Posted by: Don the libertarian Democrat | December 17th, 2008 at 5:57 pm |