Helicopter money has to be in the tool kit

‘It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.’

This comment of Mark Twain applies with great force to policy on money and banking. Some are sure that the troubled western economies suffer from a surfeit of money.

Meanwhile, orthodox policy makers believe that the right way to revive economies is by forcing private spending back up.

Almost everybody agrees that monetary financing of governments is lethal. These beliefs are all false.

When arguing that monetary policy is already too loose, critics point to exceptionally low interest rates and the expansion of central bank balance sheets.

Yet Milton Friedman himself, doyen of postwar monetary economists, argued that the quantity of money alone matters.

Measures of broad money have stagnated since the crisis began, despite ultra-low interest rates and rapid growth in the balance sheets of central banks.

Data on “divisia money” (a well-known way of aggregating the components of broad money), computed by the Center for Financial Stability in New York, show that broad money (M4) was 17 per cent below its 1967-2008 trend in December 2012.

The US has suffered from famine, not surfeit.

Financial cycle

As Claudio Borio of the Bank for International Settlements puts it in a recent paper, “The financial cycle and macroeconomics: what have we learnt?”, “deposits are not endowments that precede loan formation; it is loans that create deposits”. Thus, when banks cease to lend, deposits stagnate.

In the UK, the lending counterpart of M4 was 17 per cent lower at the end of 2012 than in March 2009.

Those convinced hyperinflation is around the corner believe that banks expand their lending in direct response to their holdings of reserves at the central bank. Under a gold standard, reserves are indeed limited. Banks need to look at them rather carefully.

Under fiat (that is, government-made) money, however, the supply of reserves is potentially infinite.

True, central banks can pretend reserves are limited. In practice, however, central banks will advance reserves without limit to any solvent bank (and, as we have seen, to insolvent ones).

With central banks able to supply reserves at will, the constraints on lending are solvency and profitability.

Expanding banking reserves is an ineffective way to increase lending, not a dangerous one.

In normal circumstances, bank lending responds to changes in interest rates set by central banks.

But, as Lord Turner, chairman of the UK’s Financial Services Authority, argued in an important lecture given last week, “Debt, Money and Mephistopheles”, this lever is broken.

The response of policy makers is to try even harder to make the private sector lend and spend. Central banks can indeed drive the prices of bonds, equities, foreign currency and other assets to the moon, thereby stimulating private spending.

But, as Lord Turner also argues, the costs of this approach might turn out to be high. There is “a danger that in seeking to escape from the deleveraging trap created by past excesses we may build up future vulnerabilities”.

William White, former BIS chief economist, expressed a similar concern in a paper on “Ultra Easy Monetary Policy and the Law of Unintended Consequences”, last year.

Alternatives exist. As Lord Turner notes, a group of economists at the University of Chicago responded to the Depression by arguing for severing the link between the supply of credit to the private sector and creation of money. Henry Simons was the main proponent. But Irving Fisher of Yale University supported the idea, as did Friedman in A Monetary and Fiscal Framework for Economic Stability, published in 1948.