I Hate Those Blurred Lines! Monetary Policy and Fiscal Policy: Daily Focus

…because I’ve been there…. I had my road-to-Damascus moment… in 1998…. Back in 1998 I… believed that the Bank of Japan could surely end deflation if it really tried. IS-LM said not, but I was sure that if you really worked it through carefully you could show… doubling the monetary base will always raise prices even if you’re at the zero lower bound…. (By the way, I screwed up the aside on fiscal policy. In that model, the multiplier is one.)

To my own surprise, what the model actually said was that when you’re at the zero lower bound, the size of the current money supply does not matter at all…. Doubling the current money supply and all future money supplies will double prices. If the short-term interest rate is currently zero, changing the current money supply without changing future [money] supplies… matters not at all….

As a result, monetary traction is far from obvious. Central banks can change the monetary base now, but can they commit not to undo the expansion in the future, when inflation rises? Not obviously…. But, asks Evans-Pritchard, what if the central bank simply gives households money? Well, that is, as he notes, really fiscal policy…. I’m pretty sure that neither the Fed nor the Bank of England has the legal right to just give money away as opposed to lending it out; if I’m wrong about this, put me down for $10 million, OK?…

I can say that! How liberating!

You are almost surely not at the zero lower bound–in the liquidity trap–because there are few worthwhile investments to be made and so desired saving at full employment exceeds planned investment.

You are almost surely at the zero lower bound–in the liquidity trap–because the credit channel has broken down. Private financial markets can no longer mobilize enough of society’s risk-bearing capacity to keep The keeper risk spreads at reasonable levels. Nobody trusts investment banks and commercial banks to have the skill, competence, and incentives to correctly classify risks and so make win-win Bond sales to savers.

Basically, those who could usefully and profitably borrow and spend is liquidity-constrained. And those who would like to lend do not believe they can distinguish those who could usefully and profitably borrow from those who would simply take the money and run.

But even though private financial markets cannot mobilize risk-bearing capacity–in large part because nobody outside trusts the investment banks that could distinguish between sound and unsound long-run risks to be sound themselves, and so the limits to arbitrage have been reached (see Murphy and Shleifer)–the central bank can.

This is the point of the Bagehot Rule:

[The central bank] must lend to merchants, to minor bankers, to ‘this man and that man’…. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them…. The ultimate banking reserve of a country (by whomsoever kept) is not kept out of show, but for… meeting a demand for cash caused by an alarm…. [W]e keep that treasure for the very reason that in particular cases it should be lent…. [W]e must keep a great store of ready money always available, and advance out of it very freely in periods of panic, and in times of incipient alarm…. The way to cause alarm is to refuse some one who has good security to offer…. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security–on what is then commonly pledged and easily convertible–the alarm of the solvent merchants and bankers will be stayed…

Lend freely on “what in ordinary times is reckoned a good security–on what is then commonly pledged and easily convertible”.

This isn’t fiscal policy: once the economy has rebalanced the collateral is “good security” again, so the central bank acquires an asset that is, after the storm is passed and when the sea is calm again, worth more than the money it has lent.

This, however, does enrich those to whom the government lends: they value the cash the government lends to them in the crisis very highly, and so they spend it. The Bagehot rule says that the lending should be done at a “penalty rate”–so that nobody is happy that they had to resort to the discount window, and everybody wishes that they had been more prudent during the previous boom-bubble and had been able to ride out the crisis without support. But lend. This is expansionary. And it is not fiscal policy–the government is not giving money away or spending money by buying assets at prices that worsen its own future fiscal position and raise its debt.

This is what the Treasury and the Fed did during 2008-9 for too-big-to-fail financial institutions–albeit not at a penalty rate: lending to Goldman Sachs at 5% without obtaining any control rights at a time when Warren Buffett was demanding 10%, heavy option kickers, and control rights if things went seriously south was uncool. Lending to a Citigroup that was insolvent under any definition–that still, in spite of its enormous subsidies, has not recovered even 10% of its pre-crisis equity value–without as part of the “penalty rate” claiming 100% of the equity was seriously uncool. Yes: we are looking at you, Paulson, Bernanke, Geithner, Bush, Obama.

But there is no reason why, if the forecast is for continued depression, this policy should stop at too-big-to-fail financial institutions. They are not the only organizations and individuals that are liquidity-contrained by the collapse of the credit channel and the depression. They are not the only places where the Fed can do asset swaps that are truly not fiscal policy–i.e., not a net loss for the Fed given its time horizon–and yet are stimulative.

So: lend to everyone.

Lend to banks.

Lend to auto companies.

If things are bad enough, allow individual households to incorporate themselves as bank holding companies, join the Federal Reserve system, and borrow at the discount window on the security of their cars, their houses, their washing machines.

Do this at a penalty rate so that nobody is happy that they wedged themselves and had to resort to the discount window–which means taking equity-option kickers from individuals and corporations and decapitating the leadership of financial institutions that ought to have known better that find themselves forced to resort to the discount window. But do it.

How effective will such expanded Bagehot-Rule policies be? Are they the credit-channel equivalent of the real balance effect used in the 1940s to claim that Keynesian depressions were not really “equilibria”–a clever theoretical point, of no practical-policy force whatsoever?

I am not sure.

But it would have been really nice if somebody had tried it in 2008-9, so that now we would know.