In my book, I explore the efficacy of our various forms of “stimulus,” which are usually broken down into monetary stimulus (lower interest rates and QE) and fiscal stimulus (deficit spending, tax cuts, and redistribution.) Another type of stimulus, which blurs the line between monetary and fiscal, is for the central bank to inject newly-created money directly into people’s bank accounts. Instead of swapping money for government debt, as with QE, the central bank would hand out money for free. This is a new, untested, and highly experimental form of economic stimulus, and because it wasn’t receiving mainstream coverage at the time I was writing my book, I didn’t explore it in great depth. So I thought I’d share a few thoughts now.
Today’s monetary stimulus is very good at affecting the actual interest rate. Remember that the actual interest rate is the rate which the central bank can manipulate. This contrasts to the ideal interest rate, which is that perfect rate which balances savings and borrowing at full employment. The goal of the central bank, therefore, is to match the actual rate to the ideal rate and keep our economies at full employment. If the actual rate is above the ideal rate, the economy suffers from unemployment and below-target inflation; while if the actual rate is below the ideal rate, the economy suffers from above-target inflation. (This is all explained in greater detail in my book.)
During the financial panic of 2008, when market participants were nervously dumping financial assets for cash, actual rates were skyrocketing. Concurrently, the ideal rate was plummeting, since everyone desired to save more and borrow less. In this toxic environment where the actual rate was far above the ideal rate, QE was instrumental in reversing the direction of actual rates, sending them back down towards 0%.
Once the immediate panic was over, however, the usefulness of QE became more suspect. With actual interest rates already at rock bottom, and the ideal rate still in negative territory, what was (and still is) needed is policy that drives the ideal interest rate higher. Advocates of prolonged monetary stimulus say that QE achieves this goal in two ways. First, it raises inflation expectations, which in this model pushes the ideal rate (which is nominal) higher. And secondly, it boosts demand through the wealth effect. The logic behind the wealth effect is that higher asset prices spur people to save less and borrow more.
Of the two, the wealth effect argument is the more plausible from a common sense perspective, although the size of the wealth effect has not been enough, on its own, to return us to full employment. This is partly because the benefits of higher asset prices accrue primarily to the rich, who have higher propensities to save. So the rich are richer, but they’re still not spending enough.
The inflation expectations argument, on the other hand, is pure bunk. As Brad De Long said, the idea that inflation expectations would rise just because the Federal Reserve commits to infinite QE is as tenuous as the argument that the confidence fairies would punish large-deficit countries with higher borrowing costs. Both rely on speculative, anti-common sense ideas about how people respond to events. And six years after the financial crisis, neither has proved true.
So what’s to be done? Now that our monetary tools are exhausted, and with fiscal stimulus blocked by partisan gridlock, it’s only normal that economists are exploring the experimental notion of direct injections of newly-created money into people’s bank accounts. Whereas the best QE can do is replace financial assets with money, direct injections can add money to the financial assets income earners already hold. In essence, it can increase wealth directly. The hope is that, since we’re all wealthier (not just the rich), we’ll save less and borrow more at a given interest rate, thereby pushing the ideal interest rate into positive territory.
It’s an intriguing, but also flawed, proposal. I’ll touch on two problems. The first (and smaller) problem is that it relies on the very same wealth effect that pro-QE advocates use. Just because people are wealthier, doesn’t necessarily mean they’ll spend more.
Of course, since this money is flowing to the poor as well as the rich, the chance of increased demand is higher. And while the link between QE and asset prices isn’t direct, the link between direct injections and wealth is. Today, Janet Yellen cannot arbitrarily decide to double the price of the S&P 500 in order to achieve a meaningful wealth effect. But if Yellen were in charge of direct cash injections to taxpayers, she could double the country’s wealth. If a 5% wealth boost isn’t enough to return us to full employment, she could increase it by 10% or 20%.
So overall, direct injections of new money would juice the wealth effect much more potently than QE.
But this brings us to the second, and more fatal, problem: the problem of calibration. How much of this new money should be created and given to people? How much of a boost to the national wealth is needed for full employment? The total net worth of US households is now over $80 trillion, up from $55 trillion in the depths of the crisis. A 10% increase in wealth would translate to $7.5 trillion in new money, which is about 40% of GDP. While this amount is nowhere near the $35 trillion in new wealth created since the advent of QE, this is still a worryingly large amount of money, which, if suddenly spent, could unleash devastating inflation before the government and central bank have time to react*.
Furthermore, even if we did know the exact amount of new money that’s needed (which we don’t), this number is constantly changing. While the economy may cope well with $1 trillion in excess cash one day, it might not the next day. It might need more, or it might be less. In other words, with so much liquidity in the system, the government and the central bank would always be one slow move away from crippling inflation.
Despite these flaws, direct injections of new money are an important step in the right direction. My hope is that they will help make the bridge to what I think is the more sustainable and effective solution laid out in my book. So we should experiment. But experiment with caution.
*Some might say that what’s small as a percentage of wealth is large as a percentage of income. But once we start thinking of the injections as income, we have to consider the possibility people will wonder how many years these boosts will last for. If they think they’re only temporary, then they are likely to save a large portion of this incremental income. And if they save the money, then we need to view the injections not as income, but as wealth.
Even if people do spend a large portion of this income, the economy still needs this temporary demand boost to feed an upwards expectations spiral (unleash animal spirits), which hopefully would push the ideal interest rate back into positive territory. Otherwise the ideal rate won’t budge and the economy will slump back to where it was before the injection (or maybe just above, due to whatever wealth effect is caused by this extra cash). This problem dogs all temporary stimulus — it only works if the negative ideal interest rate is caused by depressed expectations. In other words, it works on the premise that, if only people felt better about the economy’s prospects, then they would desire to save less and borrow more at a given interest rate. And what better way to achieve this outcome than a fiscal shock-and-awe?
If the ideal interest rate is negative for structural reasons, however, then the boost to demand will only be temporary — the economy simply can’t support a higher income (GDP) than it is because saving would exceed borrowing. In times like these, we would need to consider continuous annual income injections. This would help in two ways. First, it boosts demand for every year, not just this one. And second, it becomes more likely that people will treat the injections as income, and so spend a higher proportion of the incremental dollars. Over time, growing cash hoards should enable the central bank to inject less and less as the wealth effect becomes meaningful. But here we’re back to the same worrying size of cumulative injections discussed above.