Where next? A reply to Andy Haldane

Andy Haldane is one of the world’s more thoughtful central bankers. The concerns he lays out in his most recent speech warrant attention – particularly the deflationary winds blowing from Asia, as discussed by Philip Coggan. But his analysis of what the Bank might do if UK growth slows is decidedly odd.

Tony Yates has many perceptive observations on Haldane’s proposals. My main objection concerns the omissions.

Haldane suggests that the Bank has only three options left: 1) raising the inflation target, 2) more QE, or 3) negative interest rates – perhaps combined with abolishing cash.

What’s odd is that he is prioritising highly risky, theoretically and empirically dubious policy innovations over relatively straightforward and well-understood alternatives.

Ben Bernanke was the first modern economist to clearly lay out the options we face at the lower bound of interest rates in his brilliant paper on Japan’s paralysis, written in 1999. In fact, there has been no real improvement on his proposals. Bernanke explains that in a liquidity trap the central bank can devalue the currency, try to raise inflation expectations, make commitments about future interest rates to alter the yield curve, buy assets (QE), or do “helicopter drops” – the real-world version of which is money-financed transfers to households.

We have reached the point where money-financed transfers to households are the logical contingency plan.

Bernanke never fleshed out how such transfers might be done in a way that a) preserves central bank independence, and b) provides the central bank with the necessary balance sheet armoury to reverse the effects on base money, if required. Simon Wren-Lewis, Mark Blyth and I have since filled in these gaps. Maintaining CB independence is not problematic – parliament legislates on the rule for the distribution, and the Bank controls the timing and quantity. Central bank independence – monetary policy – is defined by the control of base money. As regards the impact on the Bank’s balance sheet and its ability to reduce the stock of base money in the future, there are also straightforward measures which can be taken: either the government provides the Bank with gilts of equivalent value to the transfers when they occur, or it commits to providing gilts on demand in the future. Independence is preserved. The delineation between monetary and fiscal policy is made clear, and there is a predictable policy tool which is known to work. It is known to work because we have empirical evidence on the effects of tax rebates – and this policy is entirely analogous to a combination of QE and tax rebates.

Bizarrely, Haldane does not even consider this policy option. Instead, he gives space to ideas such as abolishing cash and having steeply negative interest rates. I am somewhat shocked that these ideas are even under consideration, because they are so patently experimental and I think, quite clearly, dangerous.

First, let’s think about abolishing cash. Cash is extremely useful – otherwise it wouldn’t exist. So the only guaranteed result from “abolishing” cash is a) resistance – because it’s useful, people will try to continue to use it, and b) a reduction in economic welfare. If people do something voluntarily in a market economy and you stop them doing it, you reduce economic welfare – except for very specific activities which people may choose to do which are harmful. Using money does not fall into this category. So a reduction in economic welfare is a guaranteed consequence of abolishing cash.

When the alternative to these proposals – i.e. money-financed cash transfers – is analogous to a fiscal transfer with predictable macroeconomic effects, this would be genuinely reckless policy-making.

Now what about negative interest rates? This is an equally strange suggestion. There is growing evidence and concern from many sources – including the highly conventional (such as Larry Summers, Glenn Stevens and Robert Merton) and the less conventional (myself and David Einhorn) – that the effect of interest rates on demand may change when rates are already this low. In simple terms, there are very good reasons why lower interest rates might reduce demand, raise the savings rate, and result in resources being diverted to managing cash and the avoidance of penal rates.

How can one believe that it is better to try something which has never been done before, which has strong theoretical and empirical arguments against it – when the alternative is economically identical to a combination of more QE and a tax cut?

I want to end on a positive note. Haldane is right to question the merits of raising the inflation target. It might have been a good idea to have had a higher target – but if the Bank is facing a recession and cannot meet its 2% target, it is hard to believe that it can credibly commit to targeting 4%.

What Haldane and his colleagues must focus on is providing a clear practical and theoretical distinction between monetary and fiscal policy policy (i.e. the control of base money), and how parliament might best legislate a rule for the distribution of helicopter drops without compromising central bank independence. Ben Bernanke told us what to do more than 15 years ago. Friedman outlined it in 1968. This would be a much better use of the Bank’s time than trying to abolish something really useful – cash.