In a previous post I argued that in the current environment, the Federal Reserve could buy up the entire stock of government bonds without triggering any incremental inflation. The argument for the ineffectiveness of conventional QE is fairly simple. Government bonds are already safe collateral both in the shadow banking system as well as with the central bank itself. The liquidity preference argument is redundant in differentiating between deposits and an asset that qualifies as safe collateral. Broad money supply is therefore unaffected when such an asset is purchased.
The monetarist objection to this argument is that QE increases the stock of high-powered money and increases the price level to the extent that this increase is perceived as permanent. But in an environment where interest is paid on reserves or deposits with the central bank, the very concept of high-powered money is meaningless and there is no hot potato effect to speak of. Some monetarists argue that we need to enforce a penalty rate on reserves to get rid of excess reserves but small negative rates make little difference to safe-haven flows and large negative rates will lead to people hoarding bank notes.
The other objection is as follows: if the central bank can buy up all the debt then why don’t we do just that and retire all that debt and make the state debt-free? Surely that can’t be right – isn’t such debt monetisation the road to Zimbabwe-like hyperinflation? Intuitively, many commentators interpret QE as a step on the slippery slope of fiscal deficit monetisation but this line of thought is fatally flawed. Inflation comes about from the expected and current monetisation of fiscal deficits, not from the central bank’s purchase of the stock of government debt that has arisen from past fiscal deficits. The persistent high inflation that many emerging market economies are so used to arises from money-printed deficits that are expected to continue well into the future.
So why do the present and future expected fiscal deficits in the US economy not trigger inflation today? One, the present deficits come at a time when the shadow money supply is still contracting. And two, the impact of expected future deficits in the future is muddied thanks to the status of the US Dollar as the reserve currency of the world, a status that has been embellished since the 90s thanks to reserves being used as capital flight and IMF-avoidance insurance by many EM countries (This post by Brett Fiebiger is an excellent explanation of the privileged status enjoyed by the US Dollar). The expectations channel has to deal with too much uncertainty and there are too many scenarios in which the USD may hold its value despite large deficits, especially if the global economy continues to be depressed and demand for safe assets remains elevated. There are no such uncertainties in the case of peripheral economy fiat currencies (e.g. Hungary). To the extent that there is any safe asset demand, it is mostly local and the fact that other global safe assets exist means that the fiscal leeway that peripheral economies possess is limited. In other words, the absence of inflation is not just a matter of the market trusting the US government to take care of its long-term structural deficit problems – uncertainty and the “safe asset” status of the USD greatly diminish the efficacy of the expectations channel.
Amidst the fog of uncertainty and imperfect commitments, concrete steps matter and they matter especially in the midst of a financial crisis. Monetary policy can almost always prevent deflation in the face of a contraction in shadow money supply via the central banks’ lender-of-last-resort facilities. In an economy like 2008-2009, no amount of open-market operations, asset purchases and monetary target commitments can prevent a sharp deflationary contraction in the private shadow money supply unless the lender-of-last-resort facility is utilised. Once the system is stabilised and the possibility of a deflationary contraction has been avoided, monetary policy has very little leeway to create incremental inflation in the absence of fiscal profligacy and shadow banking/private credit expansion except via essentially fiscal actions such as buying private assets, credit guarantees etc. In the present situation where the private household economy is excessively indebted and the private business economy suffers from a savings glut and a persistent investment deficit due to structural malformation, fiscal profligacy is the only short-term option. Correspondingly, no amount of monetary stimulus can prevent a sharp fiscal contraction from causing deflation in the current economic state.
Monetary policy is also not all-powerful in its contractionary role – it has significant but not unlimited leeway to tighten policy in the face of fiscal profligacy or shadow banking expansion. The Indian economy in 1995-1996 illustrates how the Reserve Bank of India (RBI) could control inflation in the face of fiscal profligacy only by crippling the private sector economy. The real rates faced by the private sector shot up and spending ground to a halt. The dilemma faced by the RBI today mirror the problems it faced then – if fiscal indiscipline by the Indian government persists, the RBI cannot possibly bring down inflation to acceptable levels without causing the private sector economy to keel over.
The current privileged status of the US Dollar and the low interest rates and inflation does not imply that long-term fiscal discipline is unimportant. Currently, the demand for safety reduces inflation and the low inflation renders the asset safer – this virtuous positive-feedback cycle can turn vicious if expectation of monetisation is sufficiently large and the mutual-feedback nature of the process means that any such transition will almost certainly be rapid. It is not even clear that the United States is better off than say Hungary in the long run. The United States has much leeway and flexibility than Hungary but if it abuses this privilege, any eventual break will be that much more violent. Borrowing from an old adage, give an economy too much rope and it will hang itself.