Central Banks should bet on recovery - literally

Ben Bernanke should publicly bet $1 trillion dollars that the US economy will recover quickly from deflation and recession. He should make that bet on the Fed's behalf. The Treasury should publicly disavow all responsibility for bailing out the Fed if Bernanke loses the bet. If he loses the bet, it would be paid for by printing money.

This is how people would react to the bet.

If they expect deflation and recession to continue, so they expect Bernanke to lose the bet, they will expect the Fed to print an extra $1 trillion, which would be highly inflationary.....which is a contradiction.

If they expect the economy to recover quickly, so they expect Bernanke to win the bet, they expect the Fed will not print an extra $1 trillion, so they will not expect hyperinflation, just a normal recovery, which confirms their expectation.

By making such a bet, and making it publicly, the Fed creates the very expectations it wants to create: that deflation and recession will not continue, and that the economy will recover, and return to the normal rate of inflation.

We need to refine the bet a little. It shouldn't be an all-or-nothing bet. It needs to vary continuously with the speed and extent of the recovery, so that the quicker GPD and inflation and financial markets recover, the less money the Fed will have to pay on Bernanke's bet. This creates a benign negative-feedback loop, helping people's expectations, and the economy, self-equilibrate.

The bet introduces considerable uncertainty into future money creation. But we are equally uncertain about how much money the Fed will need to create to promote recovery. The bet makes those two things, each uncertain, correlated with each other. That's good, just as the uncertain payoff of my home insurance policy is good, since it is correlated with the uncertain damage that fire will do to my home.

One way to implement such a bet would be for the Fed to buy a large amount of risky assets, where those assets would have a very high value if the economy recovers quickly, and a very low value if the economy did not recover.

Oh, wait.....

Comments

[JKH]

Nick,

Very interesting.

Another way of conceptualizing it is that Bernanke is attempting to delta hedge his short option (bet) position by adjusting to market conditions as he goes along. Indeed, I’ve always thought of Fed policy in general as a delta hedging strategy – partly encapsulated in their articulated “risk management” approach. Delta hedging essentially hedges the assumed ultimate exposure gradually and incrementally at a pace according to the intensity of incoming market changes and their effect on the ultimate probabilities.

Re - earlier helicopter money dialogue:

(I’m behind on some of your posts and perhaps related comments elsewhere.)

Are you saying that monetary policy which deliberately weakens the Fed’s capital position today assists with an objective of reflation - because it limits the ability of the Fed to take action tomorrow (i.e. buying back money it has issued) that may result in reduced seigniorage profit and capital regeneration capability?

Is it in this sense that a self-imposed contraction in central bank capital translates to a time period commitment to reflation?

Therefore, a monetary policy that gives away money and depletes current capital becomes such a capital constraint and commitment?

[Nick Rowe]

JKH: good to see you back here!

I'm going to have to think about your "delta hedging" points. But I think you are onto something. Just remember though: the average trader is trying to make a profit; while the Fed isn't (necessarily). That was my (somewhat inarticulate) point about the Fed wanting to lose the bet.

You might want to read my post a couple of weeks ago on the Bank of Canada's assets (plus the comments).

"Are you saying....." YES!

"Is it in this sense...." YES! (at least I think so, but I'm not 100% sure I catch your meaning).

"Therefore, a monetary...." YES!

One complication: it is not 100% obvious how the Treasury can make a credible commitment not to bail out the central bank. The Bank of Canada normally transfers $2 billion profit annually to the treasury. If the Bank of Canada lost *all* of its current $50 billion in assets, the only thing that would happen is that the Bank would stop paying $2 billion per year to the Canadian treasury. It wouldn't be forced to print money (except to pay its economists, and that's peanuts). So it would have to double its balance sheet (quantitative easing), *and* sell all its safe assets for risky assets (qualitative easing, in Willem Buiter's taxonomy) to damage its balance sheet sufficiently for this policy to work (I think I've got the arithmetic right).

Alternatively, the Department of Finance could just *demand* that the bank pay them $2 billion annually, by printing money if necessary. In this case, pure qualitative easing could be enough to do the requisite damage. The Bank would just sell the safe stuff, and buy garbage.

[sustain_ability]

I did naively think that the recent Federal election would have been a good opportunity to divorce ourselves from the bankrupt US economy. Now, we sit and wait for an electoral college system from the 1700's to kick in before resuming the sitting of Parliament. Oh yes, we can enjoy arcane discussions of 'delta hedging'.

As a partial survivor of the "Great Recession", a term used by a leading
financial columnist in the Toronto Star in the early 1980's, I did try
to ride it out. Eventually, it did bring me closer to God.

[lickedcat]

I was hoping someone could expatiate on the affects of higher inflation. I seems at least on the business shows that once this recession is over we will be faced with extreme inflation (or that extreme inflation will be the catalyst that ends the recession). Regardless (sorry in last 15 years I forgot most of my Economics 101 from Carleton :-) ). BTW Nick, my wife was one of your students in the early 90's. I digress, I just wanted to know what kind of strategy an average wage earner should follow when expectations of inflation are high?

Get out of fixed income and bonds and buy shares and real-estate? Buy appreciating assets and commodities?

Any clarification of the issues would be appreciated.

[Patrick]

I'm no Austrian, but they have a point when they say that debt and solvency problems are not going to be solved by monetary shenanigans.

I'm all for fiscal stimulus to bridge the gap in demand and ease the pain, but I think it would be a mistake to try to prevent the unsustainable levels of household debt, prices of some assets (e.g. housing in Calgary), and financial leverage from correcting down to historical norms.

In general, we must get used to the idea that we will consume less, use less credit, and save more. In the end, it will be healthier for the economy and for individuals; there's no better stress reducer than not owing anybody any money.

[Nick Rowe]

sustain-ability: no such luck! But really, it isn't a US problem; it's a world problem (Canadians see too much US news and not enough from the ROW). UK, Spain, Ireland, Iceland, China, Dubai, various countries in Eastern Europe, all had serious house price bubbles (and I'm sure I missed many). And financial institutions over-leveraged in many countries that didn't have a house price bubble.

licked cat: Yes, as a general rule, if you expect inflation (or if you expect inflation will be higher than current asset/prices yields account for), then buy real assets (stocks, houses, cars, commoditites etc.) and sell nominal assets (money and bonds). This is exactly what central banks in a liquidity trap want to achieve: they want you to expect inflation (not deflation), and to buy real assets and goods, to stimulate demand. I should (and perhaps did!) mention that in 43.100 15 years ago!

Patrick: I should probably post on this topic sometime. On the "Too much debt got us into this mess, now they want to cure the mess by getting us to borrow more?" idea. But in short, for now, yes, this is the cure, and it's the only possible cure. But macro-debt measures hide a lot of micro-debt issues. Who does the borrowing/spending?

[Patrick]

I'm not exactly in the "debt can't cure debt" camp, and as I said, I get that government filling the gap in aggregate demand is the only way out. And I'm not really all that worried (at least not for Canada) about deficit spending or more debt as long as there is some reasonable effort to direct the spending towards productive 'stuff', and we make some kind of commitment to paying it down once things start to turn around (maybe some kind of automatic formula based on GDP and employment growth? I dunno).

I do think that the credit fueled consumer orgy coming to an end is, in the long run, good. Instead of trying to get the party going again, it seems to me that 'we' should turn our attention to figuring out how to fill the gap with productive activity. Solving that problem is left as an exercise for the reader.

[Nick Rowe]

Patrick: OK, your position is more nuanced. But anyway, lots of people are in the "low interest rates can't cure the problem" camp, and so my new "Hair of the dog" post should still have an audience. We can switch subsequent discussion of debt to there.