Friday, March 4, 2011

Quantitative Easing Versus Printing Money

Ooooh, this one’s a doozy. I know quite a few people who will blow a gasket (make that: the whole engine block) reading this (excerpt):

Deflation, debt, and economic stimulus
Richard Wood

The US, Japan, and Ireland are suffering from deficient private demand, rising debt, and a tendency to deflation. This column is asks what can be done about it.

We begin by assuming that relevant authorities have decided that new money creation is necessary to work against deflationary tendencies and to stimulate the economy. The central issue explored here then is how should such new money creation best be deployed to create the required economic stimulus?

…Under Policy A the central bank creates new currency to purchase government bonds on the secondary market. The principal purpose is to finance a rise in bond prices and lower interest rates and, thereby, stimulate private investment. Considerable risks and side-effects could arise from the continued application of this policy in the current environment of historically low interest rates

…The alternative approach involves the central bank printing new money to directly finance fiscal stimulus. This neglected policy option – apparently largely overlooked by officials during the global economic crisis – is likely to be appropriate for countries where prices are falling (or inflation drops toward zero), private demand is deficient, interest rates are already too low and where public debt is excessive…

…Quantitative easing could be replaced with a policy of printing new money with an explicit objective to assist in the financing of future budget deficits (see suggested money-financed tax cut: Bernanke 2002 and analysis by Corden 2010). The deployment of new money creation in this manner would take some pressure off the need for severe fiscal austerity measures (at a time when continued stimulus is still required); minimise further increases in public debt; provide clear signals of policy intent (in relation to interest rate objectives, the method of financing deficits and the approach to delivering economic stimulus); and be more effective, have fewer adverse side-effects, and deliver stronger economic stimulus than further quantitative easing.

QE is controversial enough as it is; Richard Wood is actually advocating taking it a step further, though stopping short of Bernanke’s “helicopter drop” proposal.

What’s the difference?

  1. Quantitative easing – central bank buys securities on the secondary market. Since the purchases increase demand for these securities, their yields fall. If these securities are also government securities, than you’re affecting the structure of interest rates across the whole economy as all other debt instruments are benchmarked on government debt. By being selective about the maturities of the securities being purchased, you’ll also influence the slope of the yield curve.
  2. Printing money/debt financing – in this case, the central bank buys government securities in the primary market i.e. direct from the issuer, the government. This gives money directly to the government which then is supposed to spend it, hopefully as effectively as possible. You’ll also have the secondary impact on market interest rates as in QE, but without the direct liquidity injection effects.
  3. “Helicopter drop” – the two options above depend on functional financial markets and/or an active and effective government apparatus. If neither is functioning well, then you can simply print cash and give it directly to the people – as if dropping the cash off a helicopter, hence the name.

Political economy suggests that we’ll see neither option 2 nor 3 anytime soon…if ever. There’s simply too much fear of hyperinflation, however misplaced, for either to actually be implemented – note the specific circumstances that Wood sees where these policies might be effective. The problem long term is that once a government gets used to being financed this way, it might be tempted to resort to it when the current conditions don’t apply.

And that’s something nobody, not even die-hard monetarists, would advocate.

Technical Notes:

Wood, Richard, "Deflation, debt, and economic stimulus", VoxEU, March 2011

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