Suppose the monetary authority says "We already have interest rates at zero, so monetary policy can do no more to increase aggregate demand. But fiscal policy can do more..."
Suppose the fiscal authority says "We already have very high deficits and debt, so we are scared of future insolvency, so fiscal policy can do no more to increase aggregate demand. But monetary policy can do more..."
No one individual admits to a loss of faith that monetary or fiscal policy can increase aggregate demand as much as is needed. But policy is the same as it would be if there were such a loss of faith.
This is in part a follow-up to my earlier post on loss of faith. It's also a response to Tyler Cowen's good question (I will paraphrase): 'If increasing aggregate demand is so obvious and easy a solution, why ain't they doing it?'
"Reading the Keynesian bloggers, one gets the feeling that it is only an inexplicable weakness, cowardice, stupidity, whatever, that stops policies to drive a more robust recovery. The Keynesians have no good theory of why their advice isn't being followed, except perhaps that the Democrats are struck with some kind of "Republican stupidity" virus. (This is also an awkward point for Sumner, who seems to suggest that Bernanke has forgotten his earlier writings on monetary economics.) The thing is, that same virus seems to be sweeping the world, including a lot of parties on the Left."
(Scott Sumner's answer is here.)
A commenter on my "loss of faith" post, jj, left the following comment:
"So what's up with the new orthodox economists who think that printing money wouldn't work? Are they so orthodox they can't think of how to create money beyond the zero bound? Or because it has never been done in a serious country (kidding!) it is neither proven nor disproven to work, and can't be relied on? Or it's just political realism, because no serious government would try it? I mean it seems so simple and obvious, you don't even need a helicopter, just finance your fiscal programs with new money. Maybe it's TOO obvious for an economist? As a mere armchair economist I'd like to know how there can even be any debate about this."
It's just so simple and obvious; just finance your fiscal programs with new money. Money doesn't pay interest, and doesn't have to be paid back (at least, irredeemable base money doesn't), so isn't really debt, in any sense that matters.
He's basically right. (And the Neo-Chartalist/MMTers who make basically the same point are basically right too.) And, by the way, that is helicopter money, and the only real difference I can see between helicopter money and what the Australian government did by mailing out cheques to every household is that the Australian Post Office probably used "utes" rather than helicopters to deliver the mail. Same difference.
In order to explain why it isn't happening, I've got to make it less simple and obvious; I've got to make it complicated and obscure. Because that's how it will appear to the policy-makers; and explains why they aren't doing it.
Start by consolidating the government and central bank budget constraints: the deficit must be financed by issuing bonds plus issuing base money. So the policy-maker gets a choice between two ways of financing a deficit: any mix between bond-finance and money-finance.
But that's not how it appears to the separate fiscal and monetary authorities. The fiscal authority chooses the deficit. The monetary authority does not see itself as choosing the mix between money- and bond-finance; it sees itself as choosing a nominal rate of interest (and that's currently stuck at zero), so it is the market that chooses the mix between money- and bond-finance. The stock of base money is demand-determined.
So the policy-maker won't be asking "Should I make the deficit bond-financed or money-financed?". Instead, the fiscal policy-maker should be asking "Will the deficit be bond-financed or money-financed?", and the monetary policy-maker will reply "Dunno, I just set the interest rate on short-term safe loans".
That's the first complication, converting the normative question of whether the deficit ought be financed by money or bonds into a positive question of whether the deficit will be financed by money or bonds.
The second complication has to do with whether the deficit is merely temporarily money-financed or whether it is permanently money-financed. It makes a big difference.
A temporary increase in the money supply, that will be reversed 6 months later, at a time when 6 month T-bills earn near 0% interest, will make little difference. It will make no difference to the government's future tax liabilities whether it finances the deficit by bonds immediately, or finances the current deficit with money for 6 months, and then by bonds thereafter.
The helicopter money thought-experiment was always understood, at least implicitly, to be a permanent increase in the money supply. The helicopter operation was not expected to be followed by a vacuum cleaner operation 6 months later, to suck up the newly-issued money.
So, we have to change the question once again. Instead of asking whether today's deficit ought to be money-financed today, we need to ask will today's deficit be money-financed permanently?
And the answer to that question ain't so obvious.
It's not obvious to economists. More importantly, it's not obvious to policy-makers who must choose whether or not to run a deficit. And much more importantly still, because expectations matter for aggregate demand, and matter more than anything else, it is not obvious for ordinary people who make spending decisions.
At this point I am tempted to go off on an obscure rant about the disasterous consequences of central banks' choosing to promote the social construction of monetary policy as setting interest rates, because that is precisely what is making it so hard for people to see a money-financed deficit for what it is, and forming their expectations accordingly. And I am sure that part of the reason the Australian ute-money was successful is because everybody interpreted it as helicopter money because they saw a freshly-printed cheque and knew that the ute was giving everyone else the same cheque. But I won't.
Instead I'm going to return to the question: will today's deficit be money-financed permanently?
It depends. It depends first and foremost on what the central bank is targeting (inflation, price level path, Nominal GDP, whatever). It depends on whether current fiscal policy will permanently affect the variables that affect the demand for base money. It depends on how you specify the counterfactual.
Let me illustrate with a simple case. Suppose that the demand for base money is proportional to Nominal GDP. Suppose the economy goes into a recession, where NGDP temporarily falls below trend. Now let's compare two cases. In the first case the central bank targets the growth of NGDP, trying to make it increase by 5% next year over its current level. In the second case the central bank targets the time-path of the level of NGDP, trying to make NGDP return to a time-path that is growing at 5% per year. The only difference between the two policies is that if the central bank makes a mistake, so that NGDP grows at 0% one year, in the first policy it will aim for 5% growth next year, and in the second policy it will aim for 10% growth next year.
Under level targeting, NGDP will be permanently higher by 5% than under growth targeting. So base money will also be permanently higher by 5%. So there will be more money-finance of fiscal deficits under NGDP level targeting than under NGDP growth targeting. Which is a good thing, if you want to escape the recession without incurring a large debt. (That's quite apart from any other beneficial effects NGDP level targeting might have on expectations).
But at the same time, NGDP level targeting would mean that changes in the current deficit would have no permanent effect on the stock of base money, so that any change in the deficit would be 100% bond-financed in the long run.
So, is it obvious to you whether deficits will be money-financed under the current monetary regime? No, and it ain't obvious to policy-makers either. Nor to ordinary people. Maybe you do need real helicopters, to make it obvious.