Tuesday, December 16, 2008

Pulling Out the Big Monetary Guns

Martin Wolf discusses how the Fed can conduct monetary policy with its policy interest rate now near zero percent:
Central banks may soon resort to their most powerful weapons against deflation: the printing press and the “helicopter drop” of money. It is a time for which Ben Bernanke, chairman of the Federal Reserve, has long prepared. Will this weaponry work? Unquestionably, yes: used ruthlessly, it will eliminate deflation. But returning to normality thereafter will prove far more elusive. [This latter point is key--see my comments below]


Does [the Fed] face any constraint? Not really. As Robert Mugabe has shown, anybody can run a printing press successfully. Once the interest rate hits zero, the Fed can perform much further easing. Indeed, it can create money without limit. Imagine what would happen if an alchemist could transform lead into gold, at no cost. Gold would not be worth much. Central banks can create infinite quantities of money, at no cost. So they can reduce its value to nothing without difficulty. Curing deflation is child’s play in a “fiat money” – a man-made money – system.

So what might central banks do? They might lower longer-term interest rates by buying as many long-term government bonds as they wish or by promising to keep short rates low for a lengthy period. They might lend directly to the private sector. Indeed, they might buy any private asset, at any price and in any quantity they choose. They might also buy foreign currency assets. And they might finance the government on any scale they think necessary.

Alternatively, the fiscal authorities can run a deficit of any size they wish and then finance it by issuing short-term paper that the central bank would have to buy, to keep interest rates down. At the zero-rate boundary, fiscal and monetary policies become one. The central bank’s sole right to make monetary policy is gone. But the reverse is also true: the central bank can send money to every citizen. This is the helicopter drop proposed by the late Milton Friedman and recently discussed by Eric Lonergan on the FT’s economists’ forum.

I am confident the Fed can prevent deflation. What I am not confident about, though, is how the Fed will reverse its actions once the economy recovers. The Fed has been acquiring many questionable assets in its efforts to thaw frozen markets. As I discussed here, this has lead to a deterioration of the Fed's balance sheet and may impair it from being able to fully reign in all the expanded monetary base.

Update I: Jim Hamilton discusses the Fed's options going forward.

Update II: Justin Fox over at the Curious Capitalist talks with Marvin Goodfriend who believes the Fed's printing of money (i.e. quantitative easing) policy will work. He, however, shares my concerns:
The big issue, Goodfriend says, will be the exit strategy. At some point the animal spirits of businesses and consumers (and bankers) will return, and if the Fed doesn't act quickly to retire most of those hundreds of billions of new dollars it's been creating, the result will be inflation. But that's tomorrow's problem.
Don't get me wrong--I believe stabilizing nominal spending should be the key objective of the Fed at this point and, thus, quantitative easing makes sense. I am just wondering what we do after the recovery.


  1. Marvin Goodfriend: "the result could be inflation. But that's tomorrow's problem." Ah yes, the Federal Reserve's credo these past 70's tomorrow's problem.

  2. I attended a conference for economics teachers at the St. Louis Fed last month. Everyone there, from President Bullard on down, said that "there is no end game plan," and expressed the same uncertainty of how this would all end.

  3. JTapp,

    that's not very encouraging. Did the St. Louis Fed folks, nonetheless, think that quantitative easing was needed at this time?