Monetary policy in retrospect.

Lessons re-learnt. 

Monetary policy need not become impotent once interest rates reach zero.
Quantitative easing can still help generate confidence and incentivise government and private sector borrowing, even if not actually reflate the economy directly.
There are also other tools available that can effectively stimulate the economy, including forward guidance, negative interest rates, and even helicopter money.

This is an interesting paper by Paul Krugman, summarising many of his and (if I do say so myself) my own past thoughts on this issue.

He suggests that monetary policy becomes ineffective once interest rates reach zero (the 'zero lower bound', or ZLB), unless the central bank enacts significant (and most importantly, permanent) changes in policy. Even enormous temporary increases in the supply of money (as we saw from the Federal Reserve and European Central Bank following the GFC) won't feed into higher inflation. The extra liquidity just sits there. This is known as the 'liquidity trap'.

This is not a new idea. It has actually existed for 80 years. Even I acknowledged this phenomenon in some of my previous blogs (here and here). Unfortunately, many forgot it (or never knew it in the first place) when it was needed most, and opposed or delayed central bank actions following the GFC, fearing that it would spark inflation and debase the currency.

There are a couple of additions to Krugman's paper I would like to make though.

Firstly, while emergency liquidity measures during a financial crisis won't translate into significant (or even marginal) inflation, it is a necessary measure in preventing deflation. During the panic of a financial crisis, everyone (individuals, businesses, even the financial sector itself) increases their demand for money above what they normally do (as a hedge against the real or perceived risk of the crisis). And if the central bank doesn't swiftly act to meet this new demand (by increasing the money supply), the 'price' of money (as opposed to the price of goods and services, a.k.a. inflation) skyrockets. Translation - massive price deflation and unemployment.

So while this extra liquidity may not drive actual inflation and economic activity, it does act as a floor to stop the whole system tail spinning.

Secondly, by using their quantitative easing (QE) measures even after the initial panic had abated, central banks were able to buy long term assets, thereby driving long term interest rates to record lows. Simply manipulating short term rates (like central banks do in normal times) can be viewed with suspicion by private borrowers (and even government), given that this change will probably be reversed in at most a few years. But QE drove government 30-year(!) borrowing costs down to 0.24% by December 2012. This would be the perfect excuse for a government (if not the private sector itself) to borrow and invest big, thereby ending the economic slump.

Central banks also have a tool called 'forward guidance' where, through public announcement such as their regular board meeting minutes, the central bank can state its intention to keep short term interest rates low for as long as it takes the economy to recover. If credible, this expectation of short term rates remaining low for the long term will cause long term rates to fall, just like under QE. QE however, is a firmer commitment - central banks actually driving down long term interest rates directly, rather than through the credibility of their 'promise' to keep short term rates low for the long term.

So again, while QE didn't generate real economic activity and employment per se (because it was just sitting there, as per the nature of a liquidity trap), it did further support confidence that the financial sector wouldn't run out of money, as well as lowering long term interest rates (upon which a sensible government would have capitalised). Krugman himself repeatedly pleaded with government to borrow at these low rates and end the slump sooner, so this point isn't something he hasn't considered. It's just something I think wasn't sufficiently appreciated in the above paper.

Thirdly, some central banks in Europe (and Japan) experimented in the aftermath of the GFC with negative interest rates. In normal times, a government may issue a $100 bond (i.e. borrow $100), and promise to pay back $105 in a year's time. This represents a 5% interest rate that the central bank can manipulate up or down to zero. Through an Act of Parliament however, a government can technically issue a $100 bond and promise to pay back just $95 in a year - a -5% interest rate.

Given that negative interest rates were an unprecedented development, and no one was precisely sure what unprecedented evils could be unleashed by such a measure, the furthest any country dropped them was Switzerland to -0.75%. And, as it turned out, there were no unprecedented evils, and actually some positive economic results evident from being able to drop interest rates further than zero.

Fourthly, central banks can always resort (though only as a last, last resort) to 'helicopter money'. This effectively means printing money and giving it directly to the Treasury (which they can spend on infrastructure, tax cuts, etc.), or giving it to households themselves. Some, including Paul Krugman himself, suggested the Fed could mint a new $1 trillion coin, transferred directly to Treasury, to overcome the government's debt ceiling debate. The problem with the above measures is that they still rely on government and/or the private sector to exploit these easy-money conditions, borrow and invest, thereby stimulating the economy. Helicopter money (named after the exaggeration that it amounts to throwing money from a helicopter across the country) however, puts money directly into the hands of those who will spend it.

The reason this is not done during normal times is obvious - it will spark inflation. Extra money without equivalent growth in the size of the economy makes the money less valuable. But during a depression, when the economy simply needs someone (households, industry, government) to be the first to start spending (but every group, through fear and uncertainty, is waiting for someone else to be the first), helicopter money can be that necessary trigger to get normal activity underway again. But as soon as it is, the measure must be wound in.

But the reason this was not done even following the GFC was fear and, ironically, hope. Such a measure would be unprecedented (a common theme in this blog, you may have noticed), and the results could be unpredictable and hard to reverse. Furthermore, central banks rely heavily on their own credibility. QE is one thing. It involves a central bank simply increasing liquidity in the financial sector - a standard crisis response for a central bank. Helicopter money however, is effectively a way to bypass the government's responsibility for its own finances. And given the public opposition to even QE, maybe central banks weren't willing to let their credibility take another hit by enacting helicopter money.

In terms of hope, central banks were still holding out for their governments to take advantage of remarkably low interest rates and borrow. As long as they had this hope (and as long as the economy was still recovering, albeit slower than desired), they weren't willing to take the next step.

So central banks have many tools at their disposal. And while governments (especially in Europe but also the US) didn't capitalise on this once-in-80-year opportunity of record low interest rates to rebuild their countries, it does illustrate that monetary policy isn't entirely useless at the ZLB.

If only governments had the same "courage to act" (Ben Bernanke, former Fed Chairman) and do "whatever it takes" (Mario Draghi, ECB President) like central banks.