Last Friday, we posted [20]what we thought was a watershed report by Australia's largest investment bank Macquarie, one which openly called for central bank funding of fiscal spending, aka "helicopter money", by directly monetizing treasuries. Ironically, the bank made the call despite admitting that it would not work in the long run, leading to even more stagflation and deflation. This was the gist:
As velocity of money globally continues to fall, conventional QEs have to become exponentially larger, as marginal benefit declines. If public sector is not prepared to step aside, what other measures can be introduced to support nominal GDP and avoid deflation?
There are several policies that could be and probably would be considered over the next 12-18 months. If private sector lacks confidence and visibility to raise velocity of money, then (arguably) public sector could. In other words, instead of acting via bond markets and banking sector, why shouldn’t public sector bypass markets altogether and inject stimulus directly into the ‘blood stream’? Whilst it might or might not be called QE, it would have a much stronger impact and unlike the last seven years, the recovery could actually mimic a conventional business cycle and investors would soon start discussing multiplier effects and positioning in areas of greatest investment.
British Leyland (formed from nationalized British car companies in the late ’60s) destroyed its automotive industry but for a time it provided employment and investment. CBs directly monetizing Government spending and funding projects would do the same. Whilst ultimately it would lead to stagflation (UK, 70s) or deflation (China, today), it could provide strong initial boost to generate impression of recovery and sustainable business cycle.
The report was critical for two main reasons:
First, it admitted that the conventional Fed QE approach of using banks (and excess reserves) as intermediaries, is now widely accepted as a failure (as we noted earlier [21]) and that a more "acute" form of money printing would be required, one which nobody would mistake for what took place in Weimar Germany.
Second, and even more important to us, was that now that the seal has been broken on "very serious people" discussing monetary paradrops, it was just a matter of time before the entire sellside brigade jumped on board this brand new bandwagon. To wit:
"will the Macquarie report become the benchmark which the other penguins will ape as suddenly calls to bypass the banks become the norm and suddenly every "authority" on the topic, which so vehemently advocated for QE, admits it never worked from day one, and instead recommends that the only option left to save the world is the "nuclear" one?"
Today, less than a week later, we got the first official penguin in the form of Citigroup, which just released a note titled "Cold Fusion", which proposes a way to "transform ineffective monetary into effective fiscal policy."
See if you can guess what it entails (hint: "Bernanke's Helicopter Is Warming Up [22]", September 13, 2013)
This is Citi bulletin summary:
- With rates at zero, fiscal policy will be needed to offset any negative shock that hits global economies
- The practical way of doing so is for central banks to indicate that their balance sheets will remain large permanently and keep expanding if targets are missed …
- …opening the door for either additional spending or lower taxes financed by the central bank
- … a (very cold) fusion of Krugman macro, Republican tax and Bernanke (2002) monetary policies
- The policy is rates positive, so the first central bank that goes down this route will likely see its currency appreciate as the effects are felt
The details are self-explanatory but here is some more from Steven Englander:
G10 policy rates are at an all-time low but already investors are discussing what central banks will do at the next downturn. There is reason to be concerned – rates at all-time lows and balance sheets at all-time highs have not generated sufficient recovery to enable any G4 central bank to begin the normalization process. The fear is that the downward part of the cycle will start sooner than expected, precipitated either by China and EM, as our economists have argued or some other shock.
The first instinct is to say more QE, but if the expansion of balance sheets so far was not enough to avert a new downturn, there will be skepticism that additional balance sheet expansion will reverse a new slump. Moreover, the balance sheet expansion seems to have been reasonably effective at lowering yields and pumping up equities, so the slippage has not been between policy and asset markets but between asset markets and activity, and there is no strong reason to think this will change. If these historically low rates were not enough to generate a durable recovery, it is unlikely that the next 30-50bps will be enough to counter a negative shock.
To summarize: a recession is coming and conventional QE has failed. Worse, the Fed backed off its experiment at generating a reverse-psychological recovery, whereby a rate hike would have been seen as a catalyst for imminent growth (because what do they know), so the current arsenal of "tools" is useless.
Well, time to come up with a different tool. Here's Citi:
We now think that the move to central banks endorsing fiscal policy and essentially monetizing the added spending will be relatively quick and direct, in the event of a sudden slump in the global activity. When we wrote earlier on this subject we arrived at fiscal after other alternatives had been exhausted, but we now think it can be managed within the current monetary policy framework of most central banks.
Yes, the chopper.
Continuing:
The argument for fiscal policy via central bank monetization is that it directly injects purchasing power into the economy and will increase activity or inflation or both. QE increases the balance sheet but there is no guarantee that the increased lending and spending will result. In consequence many have argued for true helicopter money which is central bank financed final demand, rather than reserves creation.
Citi realizes that calling helicopter money by its true name would be a problem, so it proposes an "innovation":
Our ‘innovation’ here is to suggest that central banks will invite fiscal spending by announcing that their balance sheets will stay expanded permanently, or almost equivalently, be reduced only under extreme circumstances, and that they anticipate additional permanent expansion if targets are missed. Effectively this eliminates the government debt from the balance sheet, since any coupon payments on the debt are remitted back to the government via central bank profits. Literally the government is paying itself, which is not a bad deal if you can manage it. Many central banks are forbidden to monetize government debt, but governments will understand that permanent balance sheet expansion is an invitation to spend more, opening the fiscal channel.
Shorter Citi: it's time to unleash the biggest Ponzi ever, "which is not a bad deal if you can manage it." If you can't, it's game over.
At that point all that's left are the political considerations of how to implement this as policy:
If the government understands that the CB’s QE is permanent it opens the door to direct fiscal measures and increased demand. Congress may have different ideas on the virtues of additional spending, but they could be tempted by the prospect of Fed-funded tax cuts. There is nothing that forces fiscal policy to be highways and bridges, rather than low personal or corporate tax rates. There are plenty of Republican tax cutting proposals that rely on economic expansion or animal spirits to close the fiscal hole that the tax cut brings (for example, http://www.wsj.com/articles/how-would-the-jeb-bush-tax-plan-affect-you-1... [23]). Combine such a proposal with balance sheet expansion and you have big-time money financed fiscal stimulus. Essentially you are combing Paul Krugman fiscal with Republican tax and Bernanke 2002 {link} monetary. Government spending and infrastructure could be used as well, but it is important to understand that fiscal expansion is not synonymous with government spending.
Politically it is difficult for central banks to outright endorse monetization of government debt, but faced with another slump and armed with ineffective policy tools, we expect that central banks will quickly give the wink and nod to fiscal measures – the Fed relatively quickly, the BoJ at the drop of a hat and the ECB with an eye to warding off the growth of anti-euro political movements. If a central bank wanted absolution for this move, it could follow a rule along the following lines -- if inflation is below 1.5% use monetized fiscal policy, between 1.5% and 3% stabilize the balance sheet, above 3% inflation shrink the balance sheet (the Englander-rule, if you insist.)
The announcement that the central bank portfolios would remain permanently enlarged could have an immediate effect on inflation expectations, in addition to any impact on real expected interest rates from anticipated fiscal spending. Low policy rates at the front end and balance sheet expansion preventing the fiscal injection from pushing up medium-long term rates are a powerful stimulus combination ( I think this was Jacob Viner’s recommendation during the Great Depression). The fiscal spending means that monetary policy is pulling rather than pushing on a string so it makes both policy tools more effective.
We are not tenured economists but even we can tell you what would happen to inflation expectations: they would promptly get a "hyper" prefix.
The rates effect is very likely positive at the medium and long end as expectations of growth and inflation rise. To get the maximum activity and inflation boost the central bank may have to keep policy rates low or zero, so that short-term rates become negative relative to inflation expectations. This introduces some ambiguity into the currency effects but we think that the prospect of normalizing activity and hitting policy targets will be currency positive.
Of course, if Ponzi schemes worked then every country would just monetize its debt from day one. At least Citi acknowledges that there are risks to this lunacy:
There is the possibility that this ends up as an activity negative if the fiscal easing is promised, but not implemented, as rates would rise, effectively tightening monetary policy, without the boost form fiscal. So generating expectations without follow-through is dangerous.
Finally, lest Citigroup be accused of urging the end of the USD as a global reserve currency (because make no mistake, if and when the US launches the helicopter, this is precisely what will happen), it hedges:
We view this note as both positive and normative. The positive side is that it discusses how central banks are likely to respond if they face a negative shock when rates are already zero, and even they must be having some second thoughts on the effectiveness of QE. The normative side is that increasingly the absence of fiscal policy is viewed as one pf the reason for a less than satisfactory recovery and we outline a practical way by which central banks could endorse fiscal policy without fully dropping the idea of independence and non-monetization.
And just like that Weimar 2.0 is born.
What Citi's "innovative" proposal really means is that the idea to monetize the debt outright and to "paradrop money" is now being actively discussed among the highest circles of power, and not if but when the next recession hits, it will most likely be implemented.
Trade accordingly.
