Thomas Fazi
It’s a well-known fact that since the financial crisis the Fed and the ECB have pursued rather different monetary policies: the Fed has engaged in large amounts of quantitative easing (QE) –purchases of mortgage-backed securities and other securities such as government bonds –, while the ECB has relied on more conventional monetary policies (the lowering of interest rates and long-term refinancing operations).
Many experts attribute the fact that the US has recovered much better, in economic terms, than the eurozone (EMU) to the more expansionary monetary policy pursued by the Fed, and argue that the time has come for the ECB to engage in QE as well. But this is a gross simplification. There’s growing evidence that QE has had almost no effect on the real economy and economic recovery: loans to American businesses and households are still well below pre-crisis levels, despite the massive increase in base money (central bank reserves). This is because QE – or better, the idea that QE is the optimal tool to revive an economy in recession – is based on a fallacious view of how monetary system works.
The monetarist or quantitative theory of money – which took hold in the 1980s and is still dominant in most central banks – asserts that banks need excess reserves before they can loan out deposits (according to the so-called ‘money multiplier’) and thus that central banks can directly, or exogenously, control the money supply by influencing the reserve requirements of banks or by increasing reserves through QE (even more so, supposedly, if such reserves are obtained by offloading toxic assets from the banks’ books). The economic corollary to this theory is the so-called ‘wealth effect’, a variation on the classic (and blatantly disproven) ‘trickle-down theory’. This is the belief that virtuous economic cycles don’t begin with increased demand but rather with increased equity prices, with rising asset prices leading to beneficial effects in consumer sentiment, retail spending, along with corporate capital expenditure and hiring.
How Is Money Created?
As post-Keynesian theory explains, though, the causality actually works in reverse: when a bank makes a new loan, it simply taps some numbers into a computer and creates brand new money ‘out of thin air’, which it then deposits into the borrower’s account. Only then, if it has insufficient reserves, does the bank turn to the central bank, which is obliged to provide reserves on demand. Pre-existing deposits aren’t even touched – or needed, for that matter. In short, the money supply, not unlike the rest of the economy, is endogenously demand-driven, and central banks can only hope – at best! – to indirectly influence it by adjusting their key interest rates (the rates at which private banks can loan money from the central bank).
The ‘monetary transmission mechanism’ isn’t ‘broken’ – it never existed in the first place. This is why in the face of weak demand (even in the ‘recovering’ US) – in which the economic and profitability prospects offered by the real economy are so dim that banks refuse to lend, and people and businesses hold on to their cash instead of spending and investing (assuming they are lucky enough to actually get a loan) – credit dries up, regardless of the amount of QE that a central bank engages in.
After all, if injecting liquidity into the banks resulted in part of that liquidity ‘trickling down’ to the real economy, we would have seen some improvements in lending in the EMU as well. In fact, it would be unfair to accuse the ECB of having pursued a ‘restrictive’ monetary policy – at least in regard to the financial sector. It’s well known that the ECB has loaned to banks more than one trillion euros at record-low interest rates since the start of the crisis. And yet lending to businesses and households in the eurozone is in free-fall, and last year actually registered the sharpest drop in twenty years. Unsurprisingly, from a post-Keynesian standpoint, given that the eurozone is a step away from deflation.
So what is the United States’ improved recovery attributable to, if not to QE? In the immediate aftermath of the financial crisis (2008-10), both currency areas resorted to deficit spending to finance the holes in public budgets that resulted from unemployment benefits shooting up and tax revenues falling. From a social and economic standpoint this made a lot of sense. It functioned as a circuit-breaker and allowed the European economies to recover rather swiftly from the post-crisis crash, as testified by the mild growth rates registered in the 2010–11 period. In fact, temporary economic stimulus was ‘probably the most important reason we didn’t have a full replay of the Great Depression’, Paul Krugman writes.[1]
Then, in 2010, the trajectories of the two economies started to diverge dramatically: as Europe succumbed to the budget-slashing dogma of austerity, internal devaluation and ‘structural adjustments’, the post-crisis stimulus policies were dramatically reversed and the continent plunged back into recession (as various economists had predicted); the US, on the other hand, kept running large deficits all through to last year (when the government started cutting back on public spending). Herein, to a large degree, lies the explanation of the improved performance of the US vis-à-vis Europe. Of course, the expansionary fiscal policies pursued by the US government were made possible by QE, which kept US sovereign borrowing costs down. In this sense, QE did work, but only to the extent that it allowed the US government to run fiscal deficits without incurring higher debt-servicing costs (unlike what happened in Europe, as we know).
QE As A Policy Tool
What this means is that, when speaking of QE, it’s important to differentiate between QE as a purely monetary tool and QE as a monetary-fiscal tool: i.e., an expansionary monetary policy meant to facilitate an expansionary fiscal policy. The two are radically different. It’s unclear in which category the Fed’s QE falls: while the Fed’s policies were most likely not aimed at an increase in fiscal deficits, Ben Bernanke made it pretty clear that he would not get in the government’s way (barring runaway inflation, which was extremely unlikely given that the Fed was fighting off deflation in the aftermath of the crisis). This shows that the Fed is much less ‘independent’ than often assumed; as Bernanke recently stated, ‘of course we’ll do whatever Congress tell us to do’: if the Congress is not satisfied with the Fed’s actions, it can always tell the Fed to behave differently.[2] In this sense, the US government’s decision to cut back on spending (see last year’s decision to cut food stamp benefits to more than 47 million people) – despite continued QE – appears like an entirely political choice, in which the central bank had little or no say (unlike in EMU). The same can be said for the UK government’s austerity programme, also pursued in the face of massive purchases of government bonds by Bank of England.
What does all this mean for Europe, and what options does the continent have to escape its deadly mix of near-zero inflation, stagnation (or outright recession in various periphery countries) and growing unemployment and inequality? One option, as mentioned, is for the ECB to engage in QE. But mainstream proponents of QE, unfortunately, don’t view this as a way to increase fiscal deficits in the EMU but as a purely monetary tool. This, for the reasons outlined above, would have almost no impact on the real economy. This policy option should thus be avoided: QE as a purely monetary tool is part of the problem, not of the solution.
As post-Keynesian theory explains, and as the United States’ example proves, monetary policies alone – even unconventional monetary policies such as QE – are not sufficient to fight recessions; they have to be combined with stimulatory fiscal policies. As we all know, though, the Maastricht framework – further tightened by the Fiscal Compact – severely limits the fiscal autonomy of member states, especially those with ‘high’ levels of public debt. Technically, of course, the ECB could allow individual members states to pursue a debt-funded deficit increase by activating a non-conditional (unlike the OMT) bond-buying program – thus becoming a full-fledged lender of last resort – to keep borrowing costs down. But we all know that is not going to happen. Moreover, a debt-based stimulus would send the debt levels of crisis-stricken countries such as Italy and Greece through the roof, even by Keynesian standards – which in turn would put further strain on the integration process and core-periphery dynamics.
A more ‘realistic’ option is that of the much-debated eurobonds, whereby the EMU would raise money as a whole, at a single interest rate, and then forward it to individual governments, each of which would be fully liable for the entire issuance. This would be a desirable solution – so long as the ECB commits to purchasing eurobonds as part of its standard monetary policy and is willing to cooperate with the EMU’s fiscal authorities – but it would require the existence of some form of ‘European government’ (or political union) that at present doesn’t exist. And Germany has made it quite clear that it is opposed to any form of debt mutualisation in the near future. So – barring an ‘exit and default scenario’ – what immediate options does that leave us within the context of the EMU? As it turns out, not all hope is lost.
The Case For Helicopter Money
There is in fact a radical solution that is gaining increased support even in mainstream circles: ‘overt money financing’, or what renowned journalist and financial economist Anatole Kaletsky calls ‘quantitative easing for the people’ (QEP). It basically consists in handing out newly created money, debt-free, directly to governments instead of banks. The central bank would in effect be financing the government’s expenditures – even simply by monetizing part of the existing debt (thus freeing up resources currently devoted to the debt service) – by ‘printing’ money. As economists Biagio Bossone and Richard Wood write, recent analyses of alternative policy options demonstrate that QEP ‘offers to deliver the most powerful stimulus possible without increasing interest rates or public debt’, and could even be implemented without violating Article 123 of the Lisbon Treaty (through the ECB’s Emergency Liquidity Assistance).[3]
Moreover, it doesn’t raise any issues of mutualisation, since present and future taxpayers, including those in core countries, wouldn’t run any risk of having to bail insolvent states or incur higher debt-servicing costs in the future. Similarly, there would be little risk of inflation, since excess liquidity could always be sterilized in the future. While most people would balk at the idea, it should be noted that QEP has been defended in the past by such eminent and diverse economists as Henry Simon, Irving Fisher, John Maynard Keynes, Abba Lerner, Milton Friedman and Ben Bernanke, and has been recently revived by a number of well-known scholars and policy-makers, including Adair Turner, member of the UK Financial Policy Committee and former chair of the Financial Services Authority.
The idea was recently championed even by Gianni Pittella, Vice-President of the European Parliament.[4] His proposal was ultimately struck down, but the simple fact that it was debated offers a glimmer of hope for the future. It is only by challenging the dominant and tragically flawed economic and monetary orthodoxy that we have any hope of escaping the crisis, and of rebuilding Europe on the basis of a socially and environmentally sustainable economy. As Martin Wolf wrote in the Financial Times: “The view that it is never right to respond to a financial crisis with monetary financing of a consciously expanded fiscal deficit – helicopter money, in brief – is wrong. It simply has to be in the tool kit”.[5]
[1] Paul Krugman, ‘Rich Man’s Recovery’, New York Times, 12 September 2013.
[2] See his statement here: http://www.youtube.com/watch?v=a7XV3vS1hAM.
[3] Biagio Bosson and Richard Wood, ‘Overt Money Financing of Fiscal Deficits: Navigating Article 123 of the Lisbon Treaty’, EconoMonitor, 22 July 2013.
[4] European Parliament, Committee on Economic and Monetary Affairs, ‘DRAFT REPORT on the European Central Bank Annual report for 2012 (2013/2076(INI))’, 6 June 2013.
[5] Martin Wolf, ‘The case for helicopter money’, Financial Times, 12 February 2013.
