Are Central Banks Really Out of Ammunition?

LONDON – The global economy faces a chronic problem of deficient nominal demand. Japan is suffering near-zero growth and minimal inflation. Eurozone inflation has again turned negative, and British inflation is zero and economic growth is slowing. The US economy is slightly more robust, although even there recovery from the 2008 financial crisis remains disappointingly slow, employment rates are well below 2007 levels, and annual inflation will not reach the Federal Reserve’s 2% target for several years.

But the debate about which policies could boost demand remains inadequate, evasive, and confused. In Shanghai, the G-20 foreign ministers committed to use all available tools – structural, monetary, and fiscal – to boost growth rates and prevent deflation. But many of the key players are keener to point out what they can’t do than what they can.

Central banks frequently stress the limits of their powers, and bemoan lack of government progress toward “structural reform” – a catch-all phrase covering trade liberalization, labor- and product-market reforms, and measures to address medium-term fiscal challenges, such as pension age increases. But while some of these might increase potential growth over the long term, almost none can make any difference in growth or inflation rates over the next 1-3 years.

Indeed, some structural reforms, such as increasing labor-market flexibility (by, say, making it easier to dismiss workers), can initially have a negative effect on consumer confidence and spending. Vague references to “structural reform” should ideally be banned, with everyone forced to specify which particular reforms they are talking about and the timetable for any benefits that are achieved.

If the core problem is inadequate global demand, only monetary or fiscal policy can solve it. But central bankers are right to stress the limits of what monetary policy alone can achieve.

The Bank of Japan recently introduced negative interest rates, and next week the European Central Bank will probably take its own rate still further into negative territory or launch yet more quantitative easing (QE). But these levers can make little difference to real economic consumption and investment.

Negative interest rates are intended to spur credit demand among companies and households. But if banks are unwilling to impose negative rates on depositors, the actual and perverse consequence could be higher lending rates as banks attempt to maintain margins in the face of the running losses they now make on their central bank reserves.

As Mark Carney, Governor of the Bank of England, has noted, negative interest rates should be used only in ways that stimulate overall global demand, rather than simply to move demand from one country to another via competitive devaluation. But achieving such stimulus via negative interest rates may be impossible. The potential for yet more QE to change behavior in the real economy is equally unclear.

This means that nominal demand will rise only if governments deploy fiscal policy to reduce taxes or increase public expenditure – thereby, in Milton Friedman’s phrase, putting new demand directly “into the income stream.” But the world is full of governments that feel unable to do this.

Japan’s finance ministry is convinced that it must reduce its large fiscal deficit by hiking the sales tax in April 2017. Eurozone rules mean that many member countries are committed to reducing their deficits. British Chancellor of the Exchequer George Osborne is also determined to reduce, not increase, his country’s deficit.

The standard official mantra has therefore become that countries that still have “fiscal space” should use it. But there are no grounds for believing the most obvious candidates – such as Germany – will actually do anything. And there is no certainty that even if all the countries that have fiscal space used it, the boost to global demand would be sufficient.

These impasses have fueled growing fear that we are “out of ammunition” to fight inadequate growth and potential deflation. But if our problem is inadequate nominal demand, there is one policy that will always work. If governments run larger fiscal deficits and finance this not with interest-bearing debt but with central-bank money – nominal demand will undoubtedly increase, producing some mix of higher inflation and higher real output.

The option of so-called “helicopter money” is therefore increasingly discussed. But the debate about it is riddled with confusions.

It is often claimed that monetizing fiscal deficits would commit central banks to keeping interest rates low forever, an approach that is bound to produce excessive inflation. It is simultaneously argued (sometimes even by the same people) that monetary financing would not stimulate demand because people will fear a future “inflation tax.”

Both assertions cannot be true; in reality, neither is. Very small money-financed deficits would produce only a minimal impact on nominal demand: very large ones would produce harmfully high inflation. Somewhere in the middle there is an optimal policy – a common-sense proposition that is often missing from the debate.

Amid the confusion, the one really important political issue is ignored: whether we can design rules and allocate institutional responsibilities to ensure that monetary financing is used only in an appropriately moderate and disciplined fashion, or whether the temptation to use it to excess will prove irresistible. If political irresponsibility is inevitable, we really are out of ammunition that we can use without blowing ourselves up. But if, as I believe, the discipline problem can be solved, we need to start formulating the right rules and distribution of responsibilities.

One thing is certain: Relying on structural reform, on purely monetary policies, or on the fiscal policies available to governments that believe that all deficits must be financed with debt will not reverse the world’s chronic deficiency of nominal demand.