Negative rates have become counter-productive – they damage the banking system and hence its ability to extend credit. This is why the ECB came up with a clever sticking plaster: the targeted longer-term refinancing operation (TLTRO) with a subsidy for bank funding, subject to banks meeting some loan targets (an extension of the original 2011 LTRO, see Delbeque 2012, and of the June 2014 TLTRO). With ultra-low rates, insurance companies' guarantees and pensions funds with defined benefit obligations are in severe difficulty. Although the extension of QE to purchases of corporate bonds, the ECB’s second recent policy innovation, does reduce costs of finance for large companies, it further cuts into returns for pension funds and insurance companies.
The example of Germany that my co-authors and I analyse in a recent ECB working paper shows that in the core Eurozone, low interest rates tend to have perverse effects, dampening the spending of the household sector (Geiger et al. 2016). In Germany, the liquid assets of savers outweigh the debts of debtors, so ultra-low rates reduce aggregate household spending, given labour income and asset prices. Moreover, higher house prices (due to low rates) increase saving for the down-payment needed to obtain a mortgage and make renters more cautious given a future of higher rents. This is another reason for lower aggregate spending relative to income. Higher house prices are also socially divisive – the affluent and their children can disproportionately overcome down-payment constraints.
In Germany only around 14% of adults own equities, so the benefits of lower rates via higher share prices are small.1 These are further reasons why the German establishment dislikes negative policy rates and QE, a leading source of tension with the ECB. In any case, while supporting the stock market in a financial crisis clearly benefits liquidity and demand, driving share prices above fundamentals has severe limits and risks future stability. In the US and UK, low interest rates and QE have been far more effective, particularly in the early years, as I explain in Muellbauer (2014a).
Low interest rates and QE are also attempts to depreciate a currency, but this beggar-thy-neighbour exchange rate stimulus now tends to result in retaliation by other central banks in the global context of weak aggregate demand, as moves in euro and yen exchange rates this year suggest.
Another German argument against QE in the form of sovereign debt purchases is that it has lowered spreads on periphery sovereign bonds below market fundamentals, and so reduced reform pressures on the respective governments. The magnitude of this effect, however, seems small. My estimates of market fundamentals, correcting for the inattention to fundamentals in 2001-2008 and exaggerated fears of Eurozone break-up in most of 2009-2012 (Muellbauer 2013, 2014b), suggest that Italy’s current 10-year sovereign spread against Germany of around 1.3% is somewhat below its fundamental, but Spain’s of 1.5% is close to its fundamental.2
Reform of the fiscal rules or helicopter money
With conventional monetary policy at its limits, central banks turned to forward guidance as a policy tool in order to help coordinate in a positive direction the expectations of the private sector in the presence of multiple equilibria. By contrast, the forward guidance of the Eurozone fiscal authorities takes the form of continually hammering into the consciousness of the private sector the importance of reducing gross government debt relative to GDP.
In these circumstances, a debt-financed fiscal expansion, whether in tax cuts or infrastructure spending, would imply negative forward guidance for the private sector, as it suggests that such easing will be temporary and will be followed by later tightening. This makes the private sector less optimistic about the future and so less inclined to spend. This expectations-based negative forward guidance channel is far more important under current circumstances than the crowding out of private investment via higher long-term interest rates that features in textbooks. Crowding out is currently scarcely an issue for investment. Given deflation and excess capacity in Europe, crowding in by improving demand growth expectations is far more likely.
Even though current fiscal rules make fiscal policy much less effective than it could be, my personal view is that under current economic conditions, fiscal expansion in the Eurozone would nevertheless benefit growth even under these rules.
The current fiscal convention is doubly foolish. First, it ignores the fact that financing costs are currently at record lows. Putting less emphasis on the ratio of gross debt to GDP and more on a measure of debt service relative to GDP, for example, using the 30-year interest rate on government debt, would make more sense and would imply greater fiscal capacity.3 Second, the focus on gross debt makes little sense when net debt – where the stock of infrastructure capital financed by government is netted off gross debt – is far more sensible. A net debt target would encourage infrastructure investment and crowd in complementary private investment, boosting economic growth and helping to provide for the future of ageing populations. Such shifts in fiscal rules, however, are likely to take some time to sink into the consciousness of the general public.
If these two ways of allowing fiscal policy to play a role in raising spending are off the agenda of European fiscal authorities, overt monetary finance offers a third, rapidly acting (and thus in some ways even better) option. The virtue of monetary finance is that it does not have to be repaid and would thus eliminate the negative forward guidance of debt-financed fiscal expansion. Indeed, with Eurozone unemployment at over 10% and spare capacity in many sectors, higher government revenues induced by higher real output would actually soon reduce gross debt relative to GDP.
‘Helicopter money’ or overt monetary finance of government would encourage spending by firms, households, and the government. A potentially important channel through which this would occur is by counteracting the current negative forward guidance emanating from the fiscal authorities.
Nothing could illustrate the potential importance of forward guidance better than Mario Draghi’s July 2012 speech: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro”. Without the ECB having to purchase Spanish or Italian sovereign bonds, sovereign spreads fell dramatically in the year that followed, greatly easing the Eurozone crisis.
A misguided attack on helicopter money
For it to work, it is crucial that overt monetary finance does not add to official measures of public debt. The recent attack on helicopter money or overt monetary finance by Borio et al. (2016) does not contradict this fundamental proposition, as clearly set out in Turner (2015), for example. Instead, they argue that the higher private bank reserves induced by overt monetary finance which are parked at the central bank need to be financed at the policy rate (if non-interest bearing reserve requirements were instead imposed, this would be an undesirable tax on banks). They say that when the central bank raises the policy rate in the future, “this is equivalent to debt-financing from the perspective of the consolidated public sector balance sheet – there are no interest savings”. They appear to be arguing that even though government debt does not visibly rise with monetary finance, from a long-run cost perspective, monetary and debt finance are equivalent.
There are at least three problems with this. The first is that if long-term interest costs were the issue, governments would not be so foolish as to focus on gross debt to GDP and would instead target debt service costs relative to GDP. The second is the implicit neo-Ricardian view of households – that households can fully see through long-run budget constraints of the public sector and are driven by 'permanent income'. The research of Deaton (1981), Carroll (1992, 1997, 2001) and Kaplan et al. (2016) suggests that, faced with liquidity constraints and individual uninsurable income risk, most households have a much more short-term outlook on the future. Overt monetary finance or cash distributions to households are therefore likely to have a demand-stimulating effect just when it is needed.
The third problem is that a future rise in interest rates would be state-dependent – it would depend on an economic recovery and the resolution of current deflationary trends. To put it another way, the argument of Borio et al. is partial equilibrium, making erroneous hidden ceteris paribus assumptions, when general equilibrium is more relevant. Schaal and Taschereau-Dumouchel (2015) develop a formal quantitative business cycle model with coordination failures.4 In their model, a money-financed fiscal expansion could shift the economy into a better equilibrium. By achieving the objective of improving the state of the economy, it is natural that interest rates and future costs of government finance would rise to somewhat higher levels. Indeed, that would be a very welcome development. The paradox is that while influential opinion formers in Germany oppose overt money finance, such a policy provides a solution to the problems they have identified with negative rates and QE as practised so far.
How to design overt monetary finance
In Muellbauer (2014a), I argued that the ECB could use public databases to send each registered voter or citizen in the Eurozone a transfer or cheque for €500 without the permission of each government. There is nothing in EU rules explicitly banning such an action. Of course, it would be far preferable to do so using each government’s tax and social security system, but it would be no surprise if a court case were to be launched in Germany with their constitutional court arguing that this kind of action violated the spirit of Article 123. One can understand the ECB’s caution under these circumstances.
The ECB faces conflicting objectives. The Lisbon Treaty’s Article 127 sets price stability as one objective, interpreted in the ECB's own target of under but close to 2% inflation, while Article 123 (preceded by the Maastricht Treaty’s Article 104) forbids overt monetary finance of governments. If price stability is the primary objective, then the temporary suspension of Article 123 should be possible to prevent the risk of deflation. Such a suspension should be conditional on an easily observable and robust criterion. For example, if core inflation is below 1% for the most recent 18 months, then the ECB should have discretion to engage in overt monetary finance. It may choose not to exercise such discretion, for example if its forecasts suggest an imminent upturn in inflation. The dangers of rigid rules that cannot adapt to changed global circumstances are all too obvious.
Given the current fiscal governance arrangements in the Eurozone, the impetus for monetary finance would have to come from the ECB. There are widespread concerns that monetary finance would ‘let the genie out of the bottle’ – that once begun, governments would become addicted to this apparently easy option. Moreover, because of the history of hyper-inflation, there is a popular association, particularly in Germany, between monetary finance and losing control of inflation.v This is why its use and level must be strictly under the control of an independent, inflation-targeting central bank.
Because of the need to separate monetary finance and fiscal decisions, the ECB should be able to offer monetary finance to each government for one year up to X% of GDP, where X might be 1 or 2. Each country’s government would then decide whether to keep fiscal policy unchanged and simply issue less debt or redeem debt, or whether to relax fiscal policy and if so, how this would be done (e.g. by tax cuts or greater infrastructure investment or some mix). The economic outcomes in each country would then depend on the details of fiscal policy in each.
Suppose the German government decided to reduce debt but otherwise pursued exactly the same tax and spending policies. Money finance would then have a positive but relatively weak effect on German private sector spending with the fall in government debt and improved expectations of future tax burdens and government spending. If the German government instead used money finance to pay out tax credits to German households or increased infrastructure spending, the short-term benefits to economic activity and indirectly for meeting the inflation target would be greater. But the decision would be entirely in the hands of the German government and not the ECB. That is why overt monetary finance under such arrangements should still count as monetary rather than fiscal policy.
The ECB could not give itself permission to switch to ‘state-dependent’ monetary finance as outlined above; this would need approval from the major Eurozone governments and the European Commission. Approval might be feasible in a comprehensive package including stronger commitments to supply-side reforms. An alternative mechanism for money finance of fiscal expenditure, perhaps politically more palatable, could occur through the European Investment Bank. Chowdhury and Islam (2014) support proposals by several prominent economists for a programme of infrastructure and productivity enhancing investment organised by the EIB in conjunction with national governments. They argue, “[t]he ECB could support this investment push by buying European Investment Bank (EIB) bonds. This approach has certain advantages. Cash-strapped national governments in the Eurozone can rely on a financing window that would otherwise not be available.” If the ECB were permitted to commit to never redeeming these bonds, the risk of negative forward guidance from the fiscal rules would be eliminated.
The Eurozone dimensions of Larry Summers’ secular stagnation hypothesis have been spelled out by Jimeno et al. (2014) and include low population growth, ageing societies, weak productivity growth, and debt overhangs. Structural reforms and improved relative competitiveness of the periphery economies must be part of the answer. Wolff (2014) is surely correct that the monetary policies used to date are not enough.
Oil and some other commodity prices have staged a modest recovery in the last few months, thanks significantly to China pumping up once more its over-extended credit channel. However, there is a significant risk of a major deflationary shock originating in China’s over-capacity of supply. The impact already felt on the global steel market may only be the beginning. Giving the ECB ‘state-dependent’ access to the overt money financing tool described above would be an invaluable insurance against such deflationary risks. The continued failure of the Eurozone economy under current policies is already leading to a dangerous populist backlash. Reform of the policy framework is overdue.
Borio, C, P Disyatat and A Zabai (2016), “Helicopter money: The illusion of a free lunch”, VoxEU.org, 24 May.
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 Similar tendencies hold for Japan, except that the excess of liquid assets over debt is even more striking. This is the major reason why the Bank of Japan’s monetary policy is not working. We warned of these risks in Muellbauer and Murata (2011). Finding that the core Eurozone is closer in economic structures to Japan than to the US or UK, makes our warning especially pertinent.
 Fundamentals are determined by relative government debt to GDP ratios, relative competitiveness and housing market fall-outs that damage the banking sector. On these criteria, given Italy’s failure to improve competitiveness and continuing high debt to GDP, its spread is a little below the fundamental. Under my Euro-insurance bond proposal (Muellbauer 2011), rules-based risk spreads would have been broadly linked to fundamentals but overweighting competitiveness crucial for long-term growth. Paid into a common insurance fund, they would have given governments clear and persistent reform incentives – unlike the noisy and often hard to interpret messages from the bond markets – as well as protecting Germany and others from a ‘transfer union’.
 It is not a perfect criterion by itself, however. While the 30-year rate incorporates financing cost expectations up to 30 years ahead, there is still the risk that these expectations could be wrong and that future rates might surprise on the up-side. It also neglects the asset side of the balance sheet, see the next point.
 In their model, the economy exhibits coordination traps: after a negative shock of sufficient size or duration, coordination on the good steady state is harder to achieve, leading to quasi-permanent recessions. A fiscal expansion, which could be money financed, can then lead to a better equilibrium state with higher output. I am grateful to Wendy Carlin for bringing this paper to my attention.
 The German phobia about money finance is based on the hyperinflation of 1921-24. Historians have emphasised the pressure of crippling post-war reparations payments on government deficits as its cause, but Jung (2009) puts more weight on the huge government debt to GDP ratio accumulated during World War I. There can be little doubt that the huge social dislocation caused by the hyperinflation lubricated the rise of Hitler. The success of the mix of money and bond finance used to energise the German economy in 1933-36 without much inflation, and even before the armaments build up, has been forgotten because of its association with Nazi rule. It was the brain-child of Reichsbank president (1933-39) and economics minister (1934-37) Schacht (see Dillard 1984 and Silverman 1998).