Friday, February 28, 2020

How to Respond to the Next Recession: Central Bank Fiscal Support

Now that it looks like like the next recession may be coming sooner rather than later, it's time to lay out what I think is clearly the best path forward for monetary policy in a liquidity trap (we should be more creative than we have been). This is an issue I've been thinking seriously since long before I worked in the Obama CEA in 2011 -- I wrote my undergraduate thesis on Japan's liquidity trap in 2003. And Japan is still in a liquidity trap. Some things never change...

Fiscal Support
My idea is simple: Fiscal Support from the Fed to the Treasury (some might call it Fiscal QE, a name I oppose, "Treasury remittances", or simply seigniorage, although I see this as slightly different). The Federal Reserve should print money, buy government bonds, and then -- crucial second step -- return those bonds to the Treasury! That's it. (Well, in fact, there are several more steps I'll discuss below, but these are the key ones...) In fact, the Fed already returns interest on the bonds it holds to Treasury. Over ten years after the first QE, in total, this has actually added up to be a substantial amount of money, and thus it is an ignored modest side-benefit of the QE program (in addition to lowering US government borrowing costs, and thus the debt).

Why would this work? I can see several channels. First, smaller deficits, or even surpluses, would encourage governments to do fiscal stimulus. (How many politicians do you know who couldn't figure out a way to spend a surplus?) In fact, most countries in liquidity traps run such large deficits that after a few years, all but the most ardent keynesians/MMT people recommend fiscal austerity to counterbalance the deficits. Fiscal stimulus is likely to carry a bit more "oomph" than merely QE alone, particularly since this is a policy with an unlimited ceiling.

Secondly, this QE + fiscal transfer is likely to be more effective even if the government doesn't enact fiscal stimulus today. Why? First, it is a bit more difficult for the central bank to unwind. In addition, if the Fed just wanted a temporary stimulus, they would just go with normal QE rather than tying their hands by transferring these bonds to the Treasury. Thus, it is a signal of looser future monetary policy, and also a signal that the Fed is serious about getting the economy on track. Recall, a key problem in a liquidity trap is that the central bank needs to "credibly promise to be irresponsible" -- to convince the public that it will generate higher inflation, even after the crisis is over. What better way to do that than with "permanent QE"? One thing to note is that the central bank will still be able to raise interest rates later on, or increase reserve requirements, and so I don't think this will, in fact, inhibit the Fed from responding to inflation later on if it is so inclined, but it's a signal that the Fed believes it needs to bring in the big guns. 

A third mechanism, albeit less important, is that, even if fiscal policy is non-reactive today, it will have to be reactive at some point in the future. This implies that people will, at minimum, expect to be taxed less in the future, or have government spending decreased by less.

A fourth mechanism is the classic QE mechanism: purchasing long-term bonds will lower long term interest rates mechanically. A fifth mechanism is that long-term interest rates imply a devaluation of the currency. However, in this case, I'll say full stop that these mechanisms are likely to be modest, but for good reasons -- fiscal policy can be expected to be expansionary and thus raise future interest rates.

Fiscal Support + Communication: 
Were I a central banker, I would not just do this policy quietly (in which case it's likely no one would notice). I would also publicly encourage the government to engage in fiscal stimulus. I would also assure market participants that the policy will be in place and ratcheted up each month, until, at a minimum, the inflation target has been hit (even better would be to raise the inflation target, and in fact price level target, or switch to a 6% NGDP target, but this can be debated elsewhere). This is akin to telling the market you will do "whatever it takes". In fact, committing to potentially doing more at first will likely allow you to do less later on.

Alternative Options:
Of course, this is not the only policy option on the table. Short term interest rates are 1.5%. It makes sense to cut them first. However, the market is smart, and it probably realizes that the Fed only has a few arrows left in this quiver. The closer the Fed gets to zero without a credible plan for what to do next, the less effective each successive rate cut will be.

Next, the Fed could go negative.  I think they should. I think this could be an effective policy particularly if the Fed subsidizes new bank loans (a la TLRTO -- the ECB's program) in addition to taxing reserves held in excess. To prevent a negative effect on total bank profits, the Fed could simultaneously provide banks with a higher positive interest rate on required reserves while taxing some smaller fraction of excess reserves over a target threshold. CBs could also tax large cash holdings of banks. I am not necessarily opposed going this route. But, I also think it will be problematic to pass along negative interest rates to depositors. I also suspect that negative interest rates, absent bank subsidies and taxes on cash holdings, could be problematic, and may be limited in how low a central bank can go (although subsidies of course are unlimited). Also, since I'm a liberal who see value in many forms of public spending, I would prefer more public spending to higher bank subsidies. (Alternatively, since I'm a capitalist who values my hard-earned money, I'd prefer receiving a tax cut to a bank subsidy.) Also, many smart economists think that negative interest rates might be contractionary. Also, are very large bank subsidies, if needed, politically feasible? I have my doubts. Still, if I were Fed Chair, I would include negative interest rates, including new loan subsidies in particular, in the arsenal. I still believe it is a crime that the Fed did not go all the way to zero in the last crisis.

The Fed can also use forward guidance. Of course they should, but talk is always cheap. If the economy and inflation recover, of course the Fed will raise interest rates, and markets know this. Also, both this policy, and plain old vanilla QE, while beneficial overall, also tend to reduce the spread between short-term and long-term interest rates. This reduces bank profits, and may make banks more likely to wait to make loans. The Fed can promise to keep interest rates zero, or at minus one, for one or two years, but can it credibly do it for 5 or 10 years? Most of the FOMC members won't even be around in five years. And the FOMC committee itself rotates every year.

This leads me to vanilla QE. Why not just do more QE? Well, yes, the Fed should. Also, after an announcement that X amount of bonds will be bought each month, if the Fed's growth and inflation targets are not met, the Fed should increase the monthly amount of bond purchases. This is what they did not do last time around, and what the BoJ has also refused to do. One argument against QE is that it was a public relations disaster. Many economists still believe it did not work. And, even though the Fed did QE last time, the economy was very slow to recover. Thus, if the Fed does merely resort to QE this time, they need to do it much more aggressively than before. They could, for example, promise to double the bond purchases every month until NGDP hits a certain target. They also would need a new way to market it.  Instead of calling it just "QE", add a name that every day bond trader bros on Wall Street can relate to: "QE on steroids", or "QE on cocaine".

How about raising the inflation target too? Of course the Fed should. That the Fed continues to maintain a 2% inflation target (that it rarely even hits), now that we know what a problem the ZLB is can be thought of as a badge of incompetence. However, the problem circa 2009-2017 was that, although the Fed had an inflation target, it did not appear to have any ability to actually hit its own target. This almost certainly damaged the Fed's credibility.

This will never happen!  Response: It already has! In fact, the Fed already remits interest payments to the Treasury, and other stuff associated with its operating profits. I've heard they have also remitted bond principal before, although I can't find a link and haven't seen any hard proof of this myself. (Update: A commenter on twitter suggests that the Bank of Japan and Bank of Sweden return principle to their govt's, but I cannot verify this.)

The ECB will never do this! Response: The ECB has also already implemented this before. The ship has sailed.

This will encourage governments to overspend. Response: That's a feature of the plan, not a bug. Indeed, if central banks do not to this, central governments likely will. The only thing stopping Trump from doing this himself is that he doesn't know he can. Indeed, this is the one drawback: if the Fed does it first, Trump will learn that it's possible, and likely do too much. However, as mentioned above, the Fed will still be able to raise interest rates and increase reserve requirements.

Would Fiscal Policy Actually Work? Response: Yes it would. I actually lean toward the low side on fiscal multiplier estimates. However, I also don't think there is any serious doubt that large fiscal stimulus is expansionary. If a government sends everyone a $10,000 check (financed by the printing press), spending and inflation will go up.

What if it Fails to generate growth? Response: Let's say for a second it had no effect at all on the economy. In that case, the only effect would be to lower the national debt with nothing lost! That's still a pretty good deal.

The Fed has the power to create money. In a downturn, the Fed should simply print money, buy the bonds, and then return those bonds to the Treasury. For the very reason that this policy can be unlimited, it's likely to be more effective than any other option. This is simply an idea whose time has come.

PS: If any of you Macro theorists out there want to write this up into a "serious" paper, I'd be interested.