Replacing Quantitative Easing

It is timely for the Federal Reserve to develop a plan to cope with the problems that will exist beyond quantitative easing (QE).  Time is in short supply.

We have a situation today where the Federal Reserve is almost certain to soon begin tapering: a tricky operation in itself.  It that operation can be successfully mounted and completed, then we should, at some later point in time, arrive at another situation, where the Federal Reserve starts to sell its mountain of assets and bonds back to the public.  That, of course, will not necessarily be straight-forward or without grave risks to continued global and domestic financial stability and domestic economic recovery, as we should expect interest rates to rise.

Even if one does not believe that QE is raising business investment and delivering stimulus to the real economy, and is not reversing the tendency toward deflation, one might nevertheless legitimately want to know how the required economic stimulus to the economy will be delivered if QE is abandoned and interest rates start to normalise.

After all, with inflation falling now for two years, the Federal Reserve cannot just remove its hand and let the tiller drift around aimlessly. The Federal Reserve has a responsibility to maintain an adequate rate of inflation and, of course, is keen to do so.

Against this background it is clear that the Federal Reserve has an imperative to develop and introduce an alternative replacement monetary policy.

Forward guidance, in its various forms, is basically a communications device: it is not a direct operational policy which determines interest rates or the money supply.

Nominal income targeting is also a device, but it begs the questions: how to raise nominal incomes?  How to reverse the deflationary tendency?  How to inject the required money into the real economy: to the unemployed, to the disadvantaged and to those workers who create economic infrastructure, all of whom have a relatively high marginal propensity to consume?

Clearly the Federal Reserve is in a very tight spot.  The Congress seems engrossed in anti-growth, anti-confidence-building gamesmanship.  Uncertainty among economic actors is high.  The never-ending crises over the debt ceiling are totally counter-productive and embarrassing for a great world power.  Ironically, while public debt in the USA is nowhere near as high as that in Japan, it is much more destructive to confidence and economic progress.

It is now essential that the Federal Reserve inform the American people and the waiting world community how it intends to proceed with monetary policy as tapering and the exit strategy get underway.  The risks to the global economic recovery of not being transparent on this point are immense.

It would be not surprising if the American President required that the US Treasury and the Federal Reserve commence discussions immediately to review prospects for achieving greater coordination between monetary and fiscal policy, with a view to announcing a plan to maintain the recovery process.  With QE virtually at an end and with interest rates as low as they can be taken, the still existing gross deficiency in aggregate demand can no longer be ignored.  It must be addressed if the pace of the recovery is to be moved to a higher trajectory.

In their deliberations the Treasury and the Federal Reserve could review alternative options to replace QE.  The replacement policy selected must counter the on-going deflationary tendency and deliver economic stimulus to the real economy, with an eye to avoiding an escalation in public debt (as has occurred in Japan and in Europe).

For special situations like this, the policy of ‘helicopter drops’ has been proposed by Abba Lerner, Milton Friedman, Ben Bernanke and many other eminent economists.  This policy possibility should be subject to serious consideration by the Treasury and the Federal Reserve.

Limited helicopter drops could be legislated and tightly controlled.  Such an approach to monetary and fiscal policy coordination will not result in massive inflation, any more than QE has led to massive inflation.  But, properly constructed helicopter drops may better counter the current tendency toward deflation and provide economic stimulus.  If at some future point, well into the future, when the economy approaches full capacity, and if excess liquidity develops, any excessive money supply can be withdrawn by sterilisation.

In essence, the temporary monetary policy paradigm needed to get onto a higher growth path is likely to be no more complicated than that required by new money financed fiscal deficits.  It would provide for relatively powerful continuing stimulus as QE is withdrawn.  There will be no more asset purchases, no increase in public debt and none of the many adverse side-effects imposed by QE.

This policy possibility is in America’s national interest.  It is not a beggar-thy-neighbour policy.  It will benefit households rather than the financial community.  It would not be a permanent arrangement, but would address the current policy vacuum until economic recovery is more secure and inflation is increased in a sustainable manner.

In Europe, where the situation is much more serious, the same policy option should also be considered.  The internal devaluation experiment has largely failed in the Eurozone countries, deflation and depression are spreading, and unemployment has reached unacceptable levels in periphery countries and elsewhere.  There appears to be no plan in place for economic recovery.