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We cannot helicopter our way out of trouble
Let's be honest with savers: dropping money on the economy will fuel inflation
20 Feb 2013
Stephen King, Group Chief Economist
It turns out that London Fashion Week isn't restricted to clothing, footwear and assorted accessories. This year the catwalk is full of economic ideas: some good, some bad and others just downright silly. Fashion goes through the occasional crisis – hems above or below the knee, femininity, masculinity or androgyny – but economics, despite its dismal reputation, is going through a far bigger upheaval.
Until recently, central bankers were supposed to keep prices stable and little else. Pre-financial crisis, the assumption was that low and stable inflation would guarantee maximum sustainable growth and, over the long run, low rates of unemployment. No more. We now, it seems, take our economic cue from Doctor Who. Jumping into a macroeconomic Tardis, we have gone back to the late 1960s. After decades of denial, policymakers now apparently believe that there is a trade-off between unemployment and inflation. Yes, the Phillips Curve is back.
For economists of a certain vintage – and I include Sir Mervyn King, the soon-to-be-former Governor of the Bank of England – this is a very odd turn of events. The Phillips Curve was jettisoned in the 1970s as, contrary to the conventional wisdom of the time, both unemployment and inflation surged. For some, most obviously Milton Friedman, this was clear evidence that that the postwar Keynesian consensus was dangerous nonsense, to be rejected by all right-minded policymakers. Now, after decades in the wilderness, the Keynesian empire is back.
Sir Mervyn King: "In the short run, we'll have to accommodate (higher inflation); it's not desirable, but that's the hand we have to play."
As Sir Mervyn himself admitted last week following the release of the Bank of England's inflation report, "in the short run, we'll have to accommodate (higher inflation); it's not desirable, but that's the hand we have to play" in order to support a recovery. This is a remarkable volte-face. Pre-financial crisis, no central banker worth his salt would ever have admitted to such a trade-off. Back then, anti-inflationary credibility was all. Now, it seems, it is nothing.
Such is the enthusiasm to restore economic activity to its pre-crisis poise that some – most vocally Adair Turner, the charismatic Chairman of the Financial Services Authority – are advocating using so-called "helicopter money". (To be fair to Lord Turner, he'd prefer to try the policy anywhere other than the UK.) This tactic involves the government of the day purposefully increasing its budget deficit by a considerable amount, funded through the sale of newly issued bonds to the central bank which, in turn, generously prints a few billion new dollars, yen, euros or pounds to provide the necessary finance. That newly minted money is then "dropped" by monetary helicopters into the economy via either a tax cut or a sizeable increase in public spending. It is, apparently,
money for nothing.
So long as an economy has plenty of spare capacity, the benefits of such a stimulus translate into higher growth rather than higher inflation. But how do we know if that spare capacity is out there? The OECD, which tries to calculate such things, keeps changing its institutional mind on this fundamental issue. Its initial estimate that the UK economy was more than 6 per cent below potential in 2009 has now been revised to less than 3 per cent. That suggests helicopter money cannot easily be justified on the basis of spare capacity alone – unless we're prepared to accept the risk of higher inflation.
I'd go further. Those who advocate helicopter money while claiming inflation won't pick up are either being disingenuous or have not fully grasped how the helicopter is supposed to take off. If helicopter money is anything other than old-fashioned fiscal stimulus in disguise, it is likely to work only if inflation and inflationary expectations head higher, while interest rates remain low. We would need to be explicit about the pain that would bring to our ageing Western societies, heavily dependent on fixed pensions. It means savers would suffer.
With interest rates at zero, the cost of borrowing can be lowered further only by raising inflationary expectations: the more inflation is expected to rise and the central bank indicates that it will do nothing to stop it, the further so-called "real" interest rates will drop. If indebted households and companies understand this, they can borrow more, knowing that their debts will be eroded by inflation. Their borrowing should, in turn, trigger more demand, increasing both output and inflation. So long as the central bank doesn't renege on its promise to allow higher inflation, the result should be a lasting recovery – even if it hurts savers in the process.
We would need to be explicit about the pain that would bring to our ageing Western societies, heavily dependent on fixed pensions. It means savers would suffer.
The case in favour of all this is Franklin D. Roosevelt's New Deal, which led to a remarkable economic renaissance in the 1930s. During the Depression, US output fell 30 per cent and prices by 20 per cent. Thanks to massive monetary and fiscal stimulus – the closest we've been to a successful application of helicopter money – output in FDR's first term rose 39 per cent while prices went up 13 per cent. FDR made no secret of his intention to raise inflation. Given what had gone before, he argued, it was morally right.
FDR's policies reveal two things. First, even with huge amounts of spare capacity, inflation can still surge: today's policymakers are far too coy about the likelihood of rising prices. Second, FDR was able to justify the pursuit of higher inflation only because of the deflation and depression which had preceded it. Today, however, the case cannot so easily be made. That, more than anything else, is the reason why in the modern era helicopter money is unlikely to remain airborne for very long – particularly in the UK, where our problems seem increasingly to be an absence of productivity, not a severe shortfall in demand.
Stephen King originally wrote this article for the Financial Times newspaper, published on 20 February 2013.