Monetary policy has likely reached the limits of usefulness, not necessarily the limits of efficacy. The efficacy of monetary policy was questionable in the first place. Multiple QE programs and low interest rates have managed to inflate assets but not to spur the economy as much as was hoped.

Monetary policy is but one class of tools available to encourage growth, fiscal policy being the other. Without fiscal stimulus, monetary policy has to work doubly hard and faces leakage in terms of risk of asset price bubbles, unequal distribution of benefits, disinflation due to increased capacity, and downward pressure on interest rates. Fiscal policy will not mitigate all of these side effects but it could reverse some of the unequal distribution of benefits and put a floor under market interest rates.

Why has fiscal policy not been engaged so far?

• Many countries’ national debt is high in relation to GDP, many on account of financial sector bailouts in the crisis of 2008.
• Austerity followed as economic orthodoxy. The Eurozone, for example, has strict guidelines on state budgets.
• Operating both monetary and fiscal easing carries high inflation risk as output is boosted to potential and could overshoot. By operating monetary policy first, excess capacity is allowed to build before fiscal policy is applied to raise capacity utilization.
• Fiscal policy is politically charged and requires strong government to obtain approvals.
• Cost of debt is another factor. Leading with monetary policy results in lower cost of debt for governments if they subsequently raise spending and seek to finance it in the bond markets.

Are we likely to see a shift towards fiscal policy?

• Japan has periodically engaged in fiscal stimulus which has seen its national debt climb from 0.5X GDP in the 1980s to over 2.5X today. Just days ago, the Abe government announced a 28 trillion JPY fiscal package.
• Japan was able to do this as the Abe government, already with a super-majority in the lower house had recently won a super-majority in the upper house, was unchallenged in the Diet.
• BoJ’s QQE and negative interest rate policy had taken 10 year JGB yields from 1.66% in 2008 to -0.29% just a week ago. Cost of debt is very low.
• Japan needs reflationary policy to revive its economy. Recent data has shown Japan sliding back from the recovery from the first dose of Abenomics.

Does Europe need fiscal stimulus, and if it did, could it become a reality?

• The European economy is still on track with the recovery triggered since the LTRO operations of late 2011. PMI data point to the durability of this recovery.
• The risks to the recovery are Brexit, both directly and indirectly should it trigger more divisions, security, which could embolden nationalists and Eurosceptics seeking to close Europe and restrict freedom of movement, and a long list of local events, such as the impending Italian legislative referendum, which could escalate and spread into more, threatening the integrity of the union.
• Even if there was cause for fiscal stimulus, Europe has strict guidelines regarding budget deficits. While these limits have often been broken, they have not been intentionally breached as part of a deliberate spending campaign. Eurozone national debt to GDP is still elevated having risen from a low 65% in 2007 to 92% in late 2014; it has receded to 90.7%, still a very high level.
• While monetary policy is coordinated by the ECB, the lack of fiscal union would mean that fiscal plans are domestic affairs. Coordination would be difficult and depend significantly on the strength of the individual member states’ governments and their ability to approve such programs. Assuming each member state budgets towards their own situation, they would find monetary policy calibrated to the collective and not to their own circumstances.
• That said, the ECB too has followed a similar path as the BoJ in QE and negative interest rate policy resulting in conditions conducive to debt financing fiscal deficits.

What are the consequences of adding fiscal policy to monetary policy?

• Monetary policy has dual impact on inflation. On the one hand lower rates spur activity, or at least facilitate activity and in that respect spurs inflation. On the other hand, low interest rates encourage over investment and over capacity which have more durable deflationary pressure. Fiscal policy mitigates this by addressing directly the demand deficiency and is therefore inflationary.
• On its own, QE and NIRP lower interest rates across the term structure. The application of fiscal stimulus increases the demand for money and bids up yields across the term structure.
• Fiscal stimulus is likely to cause currency appreciation as interest rates rise. The impact on trade is less predictable given the number of distortionary trade pacts in force and the protectionist biases in the current environment. At this stage it is likely to be neutral.
• Fiscal deficits are a prime example of kicking the can down the road as the expenditure will need to be financed and financed with long term debt. Given that most countries are running historically high debt to GDP ratios, the assumption of more debt could be destabilizing at some point. This could lead to sharper interest rates and weaker currencies.
• The crowding out of the private sector is a particular risk given that monetary policy has already exposed weak private investment and demand.
• The biggest risk is not one resulting directly from fiscal or monetary policy but the slippery slope that all analgesic solutions pose. We have witnessed how easy it is to embark on QE and rate cutting policies and how difficult it is to wean economies off such policies. The same will apply to fiscal policy. What it implies is that governments will continue to apply policies which provide short term relief but which may not treat the underlying cause of slow growth, and that the only way such policies are withdrawn is not when they are no longer needed, but when governments can no longer sustain them.

Observations:

The BoJ’s discount rate, 9% in 1980 has fallen steadily to 0.3%. The 10 year JGB yield has dropped consistently from 8% in 1990 to -0.28%.

The BoJ’s asset purchase programs have seen its balance sheet grow from 110 trillion JPY in 2010 to 436 trillion JPY expanding at 30% per annum.

BoJ ownership of JGBs rose from 9% in 2010 to 34% today. It owns 55% of Japan’s ETFs and about 1.6% of the listed market capitalization. The BoJ’s current plan involves buying 3 trillion JPY of ETFs per year. The GPIF owns about 5% of market cap.

Japan’s national debt to GDP ratio has increased steadily from 50% in 1980 to 251%. The annual rate of increase is only 4.5% but it has been increasingly almost monotonically for the last 36 years.

Inflation is still negative and not showing signs of any revival. Growth has slipped from 1.8% in Q3 2015 to 0.1% Q1 2016. Sentiment and confidence indicators are showing more weakness.

Since the imposition of negative interest rates on excess reserves JPY has strengthened from 120 to 100. It trades at circa 105 today. Also, bank deposits at the central bank have reportedly risen 20% since.

Expectations:

On July 29, the BoJ meets. Various analysts assign a significant probability to some kind of increase in QE in the form of increased asset purchases from the current rate of 80 trillion JPY p.a. as well as a rate cut from the current -0.10%.

On the fiscal front, the government has announced an eagerly awaited 28 trillion JPY stimulus package. The details as to how much will be spent when, how much will be direct (expenditure) and how much indirect (tax), and how much are existing and how much are is additional, are still not available. Rumours suggest that the direct spending portion will be small with the bulk of the package in the form of loans and subsidies.

So far the market has regarded the BoJ and the fiscal package with caution. JPY and JGBs have rallied while the Nikkei has come off.

The BoJ has a track record of disappointing the markets and expectations have become increasingly uncertain. The lack of details in the announcement of the fiscal package have also left the market sceptical.

Thoughts:

While the Prime Minister’s advisers have spoken about ‘helicopter money’, technically Monetized Fiscal Policy (MFP), Mr Kuroda has said that there was “no need or possibility” of doing it. Given that ‘helicopter money’ requires close coordination between the Ministry of Finance and the BoJ, Mr Kuroda’s thoughts should be taken at face value. No ‘helicopter money.’

Monetized Fiscal Policy is likely to be ineffective in the long run and would introduce too many new and innovative problems anyway.

A sizeable fiscal package will in any case need to be financed and given the pace of the BoJ’s QQE, it will effectively be indistinguishable from MFP. The difference is a mere technicality where under QQE the bonds are passed through private sector intermediaries and under MFP the BoJ faces the state directly. Never underestimate the propensity of public servants for pedantry when they practice to obfuscate.

In the long run, the demographics of Japan will likely prove insurmountable. And in any case, the Keynesian view of the long run is probably true. In the short term Japan needs an infusion of confidence which would involve a rising equity market, stable, positive interest rates and bond yields, and a stable currency. A monotonically decreasing currency is too high a price to pay for a rising equity market. A modest recovery in inflation is also necessary.

Adding an outsized fiscal program to the currently loose monetary policy will likely stabilize interest rates and bond yields, put a floor under inflation and give a boost to demand. QQE will be needed not only to moderate any rise in yields but to finance the budget deficit and roll over the national debt. The size of the package will need to surprise the market to be effective.

The above solution is sufficiently conventional for the BoJ and the government. It provides temporary respite, but it will not address the underlying issues in the Japanese economy.

More innovative solutions:

If we are allowed to speculate, we might consider some less conventional cures for the slow growth and weak inflation. More money, debt and spending can boost demand temporarily and even give the economy sufficient momentum for the appearance of escape velocity. However, it results in chronic dependency and ultimately, policy fatigue.

In the long run, amputation could be better than analgesic. Bankruptcy law needs to be upgraded, in particular Corporation Reorganization Law, which prolongs resolution, needs to be aligned to the Civil Rehabilitation Law (equivalent to US chapter 11.) Interest rates need to be normalized and put back up to cull unprofitable enterprise and excess capacity. Negative rates cannot persist for long without detrimental impact on the banking and insurance sector. Japan also needs to encourage immigration and labour mobility to better match labour to land, capital and technology. The stock of national debt held by the BoJ could be written down.

What is Helicopter Money?

There is still much confusion over what exactly ‘helicopter money’ means. In 1969, Milton Friedman coined the term in an extreme example to illustrate a point.

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.” (Milton Friedman, “The Optimum Quantity of Money,” 1969)

In practical terms, helicopter money would require the central bank or some other branch of government to with the authority to create money, to fund the national debt precisely through the creation of money; debt monetization. As such a more precise name for ‘helicopter money’ is Monetized Fiscal Policy (MFP).

What is the difference between QE and MFP?

In QE, the central bank buys government bonds from private investors who had bought the bonds, ultimately from the government. In MFP, the central bank buys bonds from the government. The difference seems almost academic.

So far, QE has been undertaken in the US, UK and Eurozone without deliberately targeting a budget deficit. To the contrary, countries undertaking QE have tended to at least attempt fiscal responsibility. From a prudential management viewpoint this is sound policy but from an economic growth viewpoint this is somewhat self-defeating. When the problem is not undersupply of credit but deficient demand, monetary policy drives interest rates down with low impact on growth. This has been supported by data.

MFP involves operating a fiscal deficit, either in the form of tax cuts or investment spending which is subsequently funded by the central bank. The stimulus effect comes not from lowering interest rates and providing credit or liquidity, but in directly augmenting demand. Output rises directly as a result of the fiscal expansion. Whether or not the capital infusion circulates or gets saved is a separate matter. If the economy is facing deficient private demand it may take some time for inflationary effects to spur private demand.

What are the risks of MFP?

A distinction is often made between debt financed and money financed fiscal policy. This distinction is a very fine one and is not well defined. Proponents of MFP prefer to think of the debt purchased by the central bank as permanent, or written off. The central bank not only buys the bonds of the government but that debt is either perpetual or the central bank promises to maintain its balance sheet through refinancing these bonds in perpetuity. The accounting pedant would consider this debt outstanding and not written off, but that it had a perpetual buyer of last resort. In effect the central bank becomes the lender of last resort to the state, as much as a lender of last resort to the commercial banks. There are risks associated with this role.

We have seen how difficult it has been to wean an economy off QE. The Fed is the least accommodating of the major central banks yet its balance sheet has not shrunk since 2014 despite an end to its asset purchase program. The Fed continues to maintain a 4.5 trillion USD balance sheet by reinvesting coupons and maturing principal.

We have seen also how difficult it is to wean economies off low interest rates. The Fed had planned on a gentle path of rate hikes as early as mid 2015. It has managed one rate hike Dec 2015. The next one may come before Godot. Targeting unusually low interest rates distorts the single most important price in the economy, the price of money, leading to misallocation of resources, and encouraging overcapacity which may ultimately be disinflationary while impairing the profitability and solvency of the banking and insurance industry.

There is a tangible risk that MFP once implemented is accelerated. The experiences of QE and ZIRP have shown the economy’s propensity for chronic dependence on analgesics. Since the central bank acts as lender of last resort to the state, accelerations of MPF can damage confidence and lead to a run on the assets and currency of the country.

How should the money be spent? This is a difficult question in the best of times. Most developed world economies could do with infrastructure upgrades. Better funding of medical and social insurance programs would be welcome. However, public spending is to a great extent a political matter, less so an economic one. The risk that spending is inefficient and does not make a sufficient return on investment, not to the state alone but to society, is high. Also, fiscal spending tends to be sticky upwards, meaning that it is later difficult to cut back when MFP is no longer required. In fact it would increase the probability that MFP once begun would be perpetual.

Tax cuts are another channel for MPF. Here too, the consideration will likely be more political than economic. Given the explicitly unnatural nature of permanently financing a tax rebate by monetization, the design of MFP specific tax structure will likely be highly politicized and contentious.

Unanswered questions following MFP

Since the central bank is the lender of last resort to the state it is reasonable to ask what is the capital position of the central bank, how liquid and solvent is the central bank.

What is the balance sheet of the country? What are its assets and liabilities? Is it well defined?

What happens if the central bank’s accounts were consolidated into the country’s balance sheet?

In December 2011 the ECB embarked on its first 3 year LTRO, or long term refinancing operations. This is basically a secured credit line available to banks posting eligible collateral. LTRO 1 was a great success raising 489 billion EUR which the banks used to purchase sovereign bonds and unwind inter Euro area current account imbalances. LTRO 2 was 529 billion EUR. These initial LTROs were unconditional except for collateral quality. The proceeds were used in the end to buy zero risk weighted assets, sovereigns, and helped Euro area governments to refinance at a time when the bonds markets threatened to close to them. At the same time it allowed banks to borrow cheaply and buy higher yielding assets that consumed little to no capital.

The later TLTROs carried conditions, namely that the banks would be limited to borrowing up to a proportion of their loans to the private sector. The purpose of these conditions was to spur private sector lending. Take up of TLTROs has been slow because for one, the capital consumption of private sector loans is high and so the cost of lending is less impacted by the cheap financing afforded by the TLTROs, and two, private sector demand for credit has been weak.

When the ECB announced QE in early 2016, it also initiated TLTRO II, similar to TLTRO I but with cheaper financing rates, again subject to conditions. Now take up has been very strong, 399 billion at the first auction on June 24. If the high take up is a sign that bank lending is about to accelerate and that demand for credit is rebounding, this would be good news for the Eurozone economy. There are reasons for caution. The TLTRO II auction was opened June 23, the day of the UK EU Referendum. It is very possible that the large take up of LTRO II.1 was simply a risk management reaction to a highly uncertain situation and banks wanted to raise as much liquidity they could.

We are seeing an easing of lending standards and some pick-up in demand for credit from households and businesses but it remains to be seen if this can be sustained. We are a long way from a general releveraging of the economy, which might tilt the balance in favour of equity from debt.

We have seen how effective QE can be. Not very. Not for Main Street at least. For Wall Street, QE has depressed bond yields and helped to camouflage the overvaluation of paper assets supporting them at inefficient levels for too long. More than that, the effectiveness of QE is wearing out like an over prescribed antibiotic. Now the global economy is still growing, not fast, but still growing. The US economy is in rude health. But the progression of inequality coupled with paltry growth means that the mass of the population is actually experiencing falling standards of living, even as aggregate data show improvement.

Lately, the talk of helicopter money has been gaining volume. The practical deployment of helicopter money is fiscal deficit spending funded not by tax but by debt monetization, in other words, QE. So far QE has been less effective probably because it was an attempt to clap with one hand. At last, this failure may be addressed. This may solve some issues and get the economy growing faster, hopefully to compensate for the rising inequality so that the masses may be raised out of their financial stagnation. However, there are a few minor side effects. The national debt will gro. Fiscal policy funded by tax is neutral and ineffective. Deficits will have to be increased. QE will have to continue. Just because it had limited impact in the absence of fiscal policy doesn’t mean we can stop now. Private investors have been happy to join their central banks in funding their governments, but only because there was some semblance of fiscal responsibility. Abandoning fiscal responsibility might result in an investor revolt meaning a backstop financier has to be found. Enter, again, the central banks. Bond yields may rise. Loose money sinks interest rates but loose budgets raises them. The loss of private investment demand will likely put a floor under interest rates. Central banks will have to be careful to not allow financing costs to rise too quickly increasing debt service for the government and for corporates. Bond yields are likely to stop falling, how quickly they will rise depends on the determination for further QE and the risk of investor revolt. Given how indebted countries are to begin with, central banks will likely be very careful to cap debt service for their masters.

Helicopters are usually the sign of a last ditch attempt. Hopefully this is not the case here.