We believe that a common factor in the relatively low response of real economic activity to changes in asset prices and yields is probably the fact that the euro area remains highly leveraged. The total debt of households, non-financial enterprises and the general government sector as a share of GDP is higher now than it was at the beginning of the GFC. There has been some shift from the private sector to the public sector, but the overall debt burden remains unprecedentedly high for an economy in peacetime (and for which the debt incurred during the last major war (1939-1945) has long since been worked off).
The wealth effect of higher stock prices appears to do little to boost private consumer expenditure and the lift given by higher stock prices to ‘Tobin’s q’ does not appear to have stimulated private capital expenditure much. The weaker external value of the euro has clearly increased profit margins in exporting and import-competing industries and may have boosted the stock market valuations of internationally active Eurozone-listed companies, but its effect on the volumes of exports and imports appears to be moderate (in part because a number of other countries are pinning their hopes on generating a bounce in inflation and activity through weaker exchange rates, too). Extremely low interest rates have boosted residential mortgage borrowing in Germany and caused German house prices to rise at a, by German standards, alarming year-on-year rate of six percent during several months in 2015.
Excessive indebtedness means households save much of any increase in disposable income in an attempt to pay down the debt. Highly indebted governments, prompted by necessity (limited market access) and/or by the constraints of the Stability and Growth Pact, are less likely to cut taxes or to boost public spending on real goods and services when lower debt service costs raise their disposable incomes. Corporations, even if they are not debt-constrained, are unlikely to boost investment when interest rates go down and the cost of capital falls because of persistent excess capacity amid an uncertain outlook for top-line growth and profits. Profits generated by favorable movements in asset prices (including the exchange rate) are distributed to shareholders (who save a large share of this) and used for share buybacks or debt repayment.
To the extent that monetary policy has had an effect on real activity, and will have some incremental effect on activity, it may not be entirely sustainable. This is because part of the effect has been by bringing forward demand from the future, such as major purchases, including for cars or construction. That suggests that monetary policy, even if and when it has been effective in stimulating activity, will run into diminishing returns even in sustaining the levels of activity it helped to boost.
So while the Eurozone’s IS curve may not be exactly vertical, it may well be disconcertingly close to being vertical in the future.
In short: the ECB’s attempts at reflating the economy, while admirable, have failed.
The combination of a near-horizontal LM curve and a near-vertical IS curve suggests that expansionary monetary policy is by no means guaranteed to boost demand sufficiently to achieve the ECB’s inflation target, regardless of the scale on which this is pursued. What is to be done?
Well, since admission of failure means the end of the neo-Keynesian, and monetarist system, and according to some, the end of the fiat, fractional reserve system itself, one must – according to Citigroup’s chief economist – pursue the only option left.
“Helicopter money drops (what else?)”
Our conclusion is that, in a financially-challenged economy like the Eurozone, with policy rates close to the ELB, and with excessive leverage in both the public and private sectors, balance sheet expansion by the central bank alone may not be sufficient to boost aggregate demand by enough to achieve the inflation target in a sustained manner.
This is more than an academic curiosity. Japan has failed to achieve a sustained positive rate of inflation since its great financial crash in 1990. The balance sheet expansion of the Bank of Japan since the crisis has been remarkable but ineffective as regards the achievement of sustained positive inflation and, since 2000, the inflation target. The balance sheet of the Swiss National Bank has expanded even more impressively, again with no discernable impact on the inflation rate.
We do expect the ECB’s asset purchase program will expand considerably further, with the Eurosystem’s balance sheet reaching €4,000-4,500bn over the next year or two. But we doubt that even this will be enough to achieve the inflation target of close to but below 2% on a lasting basis. It might take even greater ECB balance sheet expansion to achieve the target.
But the larger central banks’ balance sheets get, the louder will become the voices of those that criticize the power vested in unelected and mostly unaccountable central banks. In addition, it is worth remembering that the laws and regulations that underwrite and circumscribe central bank actions were written at a time when their current range of actions, let alone the potentially even larger future ones, seemed exceedingly unlikely and maybe even (in the case of the ECB) inconceivable. Political concerns likely played a role in the SNB’s decision to rely less on its balance sheet and more on negative rates when managing its currency (and indeed allowing a sharp appreciation of the Swiss franc and greater exchange rate volatility). The ‘Audit the Fed’ movement is likely to be followed by ‘Audit the ECB’ movements and eventually by explicit limits on central bank actions as their balance sheets grow to politically unacceptable levels. We do not say that moment is near, but to dismiss the idea that political limits to the size of the central bank balance sheet exist seems naïve.
Moreover, even if the ECB were to expand its balance sheet sufficiently to achieve the inflation target in the next few years (say, to €5tn or €6tn), the monetary policy toolkit would then seem to be rather empty, with little option for stimulus if and when the next downturn hits (as it inevitably will). Experience teaches that downturns do happen – either for internal or external reasons – and sometimes happen when output gaps have not been closed.What happens then? Draghi’s answer seems to be: perhaps a balance sheet expansion to €10tn or €15tn. We are doubtful that such a course of action would be both perceived to be politically legitimate and economically effective.
Why thank you for telling us 7 years later that the entire path on which global central banks set off in 2009 had been a dead end. We could say we warned you but… well, we did. Every single day.
So now what? Well, this.
Buiter concludes:
The case for helicopter money is therefore partly to ensure the euro area (and some other advanced economies) reflate powerfully enough to escape the liquidity trap, rather than settle in a lasting rut of low-flation and low growth, with “emergency” levels of asset purchases and interest rates becoming the norm.
In orderly markets and with the policy rate at the ELB, the central bank can talk loudly, but on its own – without the fiscal support required to turn its monetized balance sheet expansions into helicopter money drops – it carries but a small stick.
If, as seems possible, the ECB will increase, in H1 2016, the scale of its monthly asset purchases from €60bn to, say, €75bn, and if these additional purchases are concentrated on public debt, the euro area will benefit from a ‘backdoor’ helicopter money drop –something long overdue.
