Temporary vs. permanent quantitative easing

A permanent increase in the money supply (or one that is expected to be permanent) will have a different, and bigger, effect today than a temporary increase in the money supply (or one that is expected to be temporary). To say the same thing a different way, an increase in the expected future money supply has an effect today. I am not saying anything novel or unorthodox; just reminding us of something we already knew. Yet this distinction between temporary vs. permanent increases in the money supply seems not to occupy our attention much in discussions of quantitative easing.

Take one example: Paul Krugman's response to my post (where I argued the uncontroversial point that Neo-Wicksellian models could not help us tell whether quantitative easing would work). Paul links to a 1998 paper he wrote. The model in that 1998 paper is what you get when you take an otherwise Neo-Wicksellian model and introduce money via a cash-in-advance constraint. The CIA constraint is non-binding today (the natural rate of interest is negative, and so the nominal rate of interest hits the zero bound) but will be binding in the future (when the natural rate of interest rises, and the nominal interest rate will rise above zero). Paul uses that model to argue that quantitative easing will have no effect.

I have argued that Paul Krugman's 1998 model, with its assumption of perfect credit markets (nobody is borrowing-constrained), and its assumption of only one rate of interest (ignoring the spectrum of yields, some well above zero, on assets of differing liquidity) stacks the deck against quantitative easing.

But even if we ignore all that, it is not correct that quantitative easing will not work, even in Paul's model. Temporary quantitative easing will not work; but permanent quantitative easing will work. A permanent 10% increase in the money supply will raise the future price level by 10% (the CIA constraint will be binding in future), which raises the expected rate of inflation today, and lowers the real rate of interest today, and impacts the consumption-Euler equation today, resulting in more consumption and higher output and employment.

And I know I'm not saying anything that Paul Krugman doesn't already know.

Regardless of the model (at least, regardless of any vaguely reasonable model I can think of), quantitative easing will be more effective if it is expected to be at least partly permanent, rather than temporary. The trick is, how do we ensure that the policy is expected to be at least partly permanent?

If I read the economic historians like Scott Sumner correctly, one of the policies that lead to recovery from the Great Depression was countries' raising the price of gold. And when they raised the price of gold, people expected it would be, at least in part, permanent. It was permanent quantitative easing.

Do people today, in the UK for example, expect the Bank of England's current policy of quantitative easing to be permanent? My guess is they don't, unfortunately.

We want to have it both ways. We want quantitative easing to work, and yet we don't want to damage central banks' balance sheets, and we don't want people to fear that the policy will cause excessive inflation. We can't have it both ways. Or at least, there is a trade-off.

Take a helicopter increase in the money supply, which is permanent, and done holding present and future taxes and government expenditure constant. This damages the central bank's balance sheet. Of course it damages the central bank's balance sheet; it is giving money away! The central bank's liabilities expand, and its assets do not. And the government (by holding the paths of taxes and expenditure constant) guarantees that it will not indemnify the central bank against any losses. The losses to the consolidated government/central bank balance sheet will have to be paid for by the inflation tax. Contrast helicopter money to the UK's quantitative easing, where the Treasury has indemnified the Bank of England against any losses it might suffer.

Helicopter money is a powerful method of increasing aggregate demand. It can be thought of as a one-time lump-sum transfer payment (or tax cut) paid for by printing base money, where the government guarantees that it will not pay for the transfer by raising future taxes (so Ricardian Equivalence is moot). The current transfer will be paid by the future inflation tax, in long-run equilibrium, but that inflation tax only kicks in if the helicopter money does indeed shift the aggregate demand curve to the right and cause (eventually) a higher price level.

If quantitative easing is to have no permanent effect on the time path of the future price level, then it must be purely temporary. Any increase in the money supply today will have eventually to be fully reversed some time in the future. But if it is perceived as purely temporary, it won't work as well, and we will need a much bigger amount of quantitative easing today, to have the same effect, and so we will need a much bigger reversal in the future, and will therefore need to worry much more about the central bank's balance sheet, so that the assets it will need to buy back the money cannot be allowed to fall in value.

The more we can scare people that quantitative easing will damage the central bank's balance sheet and raise the future price level, the bigger the quantitative easing multiplier, and the less quantitative easing we will need. (Estimates of those multipliers that ignore that temporary/permanent distinction may be wildly innaccurate.) We want to scare people (up to a point). That's the whole point of the policy: to scare people out of money and safe short nominal bonds, so they buy something else instead.

It's a weird sort of game. A bit like one of those Christmas cracker games where you have to tilt the convex surface enough to get the little silver ball rolling, but then quickly tilt it back the other way before the ball rolls to far. Except the ball knows that's the game you are playing, and responds to the expected future tilt, as well as the current tilt. The central bank would rather point an inflationary gun at the money markets and say "Well, punk, are you feeling lucky?"

I can think of two ways to scare the money market by the right amount.

The first is for the central bank to buy some really bad assets. Or rather, assets that will be bad if the central bank fails, and good if it succeeds in preventing a deflationary recession. And the Treasury will guarantee that it will not bail out the bank.

The second is for the central bank to announce a price level target (or price level path target), and raise that target (relative to current expectations) in conjunction with quantitative easing.

The second policy will ensure that quantitative easing will be seen as (at least partly) permanent. The first policy ensures that the perceived degree of permanence is inversely correlated with the policy's perceived success.

There are almost certainly other ways, some possibly better, to make sure quantitative easing is seen as at least partly permanent.

Comments

[JKH]

Nick,

I see no substantive difference between helicopter money and quantitative easing.

The effect on the consolidated government/central bank balance sheet (G/CB) is the same.

Helicopter money is deficit financing.

The fact that no asset appears on the CB balance sheet in the case of helicopter money is a superficial difference. By contrast, the G bonds that appear on the CB balance sheet in the case of QE are only an internal funding mechanism from the CB to the government, where the bond rate is the “transfer price”. In the case of HM, the currency dropped is both the financing instrument for the CB and the medium of payment for the government, resulting in the corresponding deficit (e.g. transfer; tax reduction). The corresponding asset entry could be left as an omission, or could be considered a negative equity contribution, or could be converted to a government bond with a pen stroke. It doesn’t matter in substance. The effective asset liability profile in any of these bookkeeping arrangements is one of deficit financing for the consolidated entity.

Solvency of the central bank per se is also a superficial issue; solvency only makes substantive economic sense when considering it at the level of the consolidated G/CB level.

The government may guarantee not to raise future taxes, but future money is fungible.

Permanent QE can equate to temporary QE by discounting higher up front easing levels.

What about present and future velocity under permanent, temporary or no QE? You haven’t mentioned how it factors in to the policy decision.

[Matthew B]

A lot of the recent posts talk about the zero bound, which got me to thinking: in the current context, why is zero a limit?
In practical terms, what is to prevent central banks from issuing instruments which say, in effect: "here, financial institution, take $1 million. You owe us $999,995".
I realise that this is dangerous, as expectations of deflation tend to be self-fulfilling, but for a central bank, is there any circumstance in which a negative nominal interest rate would be feasible (if, for example, the institution in question was an automotive finance firm?

[Nick Rowe]

JKH: I think that helicopter money and quantitative easing do make a difference to the consolidated government/central bank balance sheet (and have different implications for the long run government budget constraint).

QE is like HM, except the G/CB gets an asset under QE. The future income from that asset can be used to finance future government expenditure, or future tax cuts, or future reductions in the supply of base money.

I agree that central bank solvency is superficial unless the government insists on receiving a given level of income from the central bank, and the central bank is trying to meet some fixed price level or inflation target. Otherwise, it just prints money to avoid insolvency.

Velocity: suppose the price level is fixed today, and perfectly flexible in the (long-run) future. Future velocity will be unchanged by either a temporary or permanent increase in the money supply. Today's velocity will fall under temporary increase in the money supply. Today's velocity will fall less, and may even rise, with a permanent increase in the money supply. I expect that's the main point, just another way of looking at it.

[Nick Rowe]

Matthew: the argument is that everybody would want to borrow an infinite amount, stick it in a safe, pay back the loan, and pocket the $5.

[JKH]

Nick,

"QE is like HM, except the G/CB gets an asset under QE."

The asset doesn't make any difference unless quantitative easing effectively finances qualitative (credit) easing, which is a big qualification. Otherwise, if the asset is a government bond, the effect on the consolidated balance sheet is a wash.

[pointbite]

"so they buy something else instead"

Nick, buy what? You never take your thoughts to their ultimate conclusion. Your blog makes me want to sell all non-essential things I own to redirect resources into food and gold, certainly not buy a new car or go on vacation. When driven by fear, and not legitimate demand, your plan will backfire when prices rise asymmetrically, food and other necessities will be hoarded and increase in price much faster than other things. People will start protesting. Which I suppose will be followed by price controls... and shortages... and rioting.

Besides, if the presence of helicopter Ben at the Fed isn't enough to scare people, then scaring is the wrong approach. Is there anybody with the capacity to understand inflation who doesn't already know Bernanke is a money printer?

[Nick Rowe]

JKH: it's the same (but simpler) if the asset is a government bond. Increase the money supply by $100. QE means $100 less bonds in public hands, compared to HM, where the money is just given away for free. So the consolidated G/CB can have lower future taxes, or higher future govt expenditure, compared to HM, because it doesn't need to pay as much interest to the public.

Pointbite: I want you to TRY to sell money, and short safe govt bonds, for stocks, commercial bonds, and (ulimately) newly-produced goods. But you will fail of course, because everyone else will be trying to get rid of money and short safe govt bonds as well. But in the process of unsuccessfully trying to get rid of money, you will spark a financial and employment/output recovery. So you end up with the same amount of money and bonds, but more neat stuff like food (and the price of gold will rise, if everyone tries to do the same as you).

[JKH]

Nick,

I was comparing QE and HM assuming an equivalent fiscal program (including transfers or reduced taxes in this case) and therefore an equivalent requirement for net financing.

Assuming this, government must issue new bonds equal to QE purchases of bonds.

Then the net financing effect is that same as HM.

Otherwise, QE purchases of market bonds alone versus HM is a comparison of two programs with an entirely different fiscal effect and financing result.

[pointbite]

Nick, you may have misunderstood my comment, I would swap non-essential for essential. So I will sell all the extra things in my basement and immediately use the money to hoard food before the massive inflationary timebomb hits, that's not selling money. Of course eventually overall demand will increase, but it will not be equally distributed, it will be skewed towards essential products. That's my point, and my concern. The last big inflation caused house prices to rise disproportionately, if the next is caused by fear it will likely cause food and alternative forms of money to rise disproportionately. It's one thing to inflate the price of art and useless collectibles, it's another to raise the price of food. That will cause an enormous amount of poverty and social unrest, I don't think that was your intention. I still think this plan is a disaster waiting to happen.

[Patrick]

pointbite: "massive inflationary timebomb"

Not gonna happen, IMO. The St. Louis Fed just released a report (sorry no link, but I think it was on Angry Bear) confirming my suspicions: the increase in base money is largely sitting in the vault (in the form of excess reserves). For the inflation scenario to happen, I think you need to explain how an insolvent and illiquid banking system in the midst of a consumption collapse and possible debt deflation spiral is likely to suddenly give up its extreme liquidity preference, and even if they did you'd have to explain why the central bank (i.e. the Fed) wouldn't be able to sop-up the additional liquidity. It's not like they won't notice the money leaving the vaults (or the electrons flowing). I'll concede that MAYBE we might possibly perhaps see interest rates spike if things suddenly turned around in a big way (which seems very, very unlikely to me). But since we are at 0%, we have a long way to run up before rates get to be onerous by historical standards.

[pointbite]

Patrick, because inflation is not just the supply of money, it's also the velocity of money. If Nick scares everyone into panic buying hoards of food the trends could change in a matter of weeks. This whole discussion is about getting savers to spend money that already exists, that has little to do with banks lending anything to anyone. There is little difference on prices between $10 spent and $5 spend twice in the same time frame. Again, ask anybody who survived the German hyperinflation, they also experienced a deflation initially, then one day the shelves had no food.

The Fed will not be able to stop it for several reasons:

(1) The price increases will initially be heralded as the success of government intervention and the beginning of a recovery. There will be intense political pressure to do nothing.

(2) Interest rates are absurdly low, if prices start to jump quickly no sane person would hold a treasury bill/note/bond at these yields. The government will not be able to mop-up liquidity with bonds and there is no way they can raise short term rates as fast as I can decide to start spending my excessive savings. There could be runs on the banks. The dollar could collapsed.

*IF* we experience a wave of fear, as Nick proposes in this post, I think this is a plausible outcome.

[Nick Rowe]

JKH: I'm still not sure I understand you.

If you are saying that HM = QE + bond-financed one-time transfer payment, then I agree.

But if not, then I think you are violating the long-run government budget constraint:

PV(Taxes) + PV(increases in base money supply (seigniorage)) = PV(govt. spending on goods) + existing stock of bonds in public hands.

[David Pearson]

Nick,

Krugman has said as much in a post (on his blog) arguing that the Fed needs to act in an "irresponsible" manner. He is saying it is the Fed's very inflation-fighting credibility that stifles the effectiveness of QE, and that the Fed needs to give up some of that credibility.

I'm not sure setting a price level target would be sufficient to influence expectations. A price level target introduces a skewed distribution of outcomes. Assume actors have a choice between cash and real assets. With an inflation target, the Fed quantifies, with some certainty, how much actors will lose if they choose to hold cash. On the other hand, if actors choose real assets they face a "fat" tail risk that they will lose a great deal on those assets. So the choice is, risk losing a great deal with real assets, or risk losing a certain quantity with cash. I believe this choice will lead to cash hoarding. If the Fed really wants to influence the choice, it has to introduce tail risk to cash hoarders, and this is inconsistent with a price level target placed by an credible Fed.

The only way to introduce tail risk to cash is to raise the possibility of hyperinflation. I believe that going off the gold standard in 1934 effectively introduced this risk. There are many other examples of maxi-devals which effectively accomplished the same goal: a maxi deval is ultimately very hard to reverse, and therefore is has the property of permanence that you are looking for. Is the Fed ready to take such a dramatic step? Or better yet, can it? Devaluation against other currencies is not an option. What about selling printed dollars to buy gold? Or simply pegging the gold price far above the current price? This has the benefit of permanence, and of not targeting another currency.

I am now outed as a wacko gold bug. The fact remains, however, that the proposals you suggest do not introduce tail risk to cash hoarders, and the Fed needs to come up with a plan that does.

[JKH]

Nick,

I’m not expressing it clearly, which means I haven’t understood it properly myself yet.

Let me try again, in a different way.

Assume a model whereby the central bank holds only government liabilities as assets. In other words, the central bank funds the government.

Then look at the consolidated balance sheet of the government and the central bank. The liability structure consists broadly of the following categories:

a) Central bank clearing balances
b) Central bank notes in circulation
c) Government debt in circulation (i.e. held by the public)

The core helicopter money transaction (HM) is a “forced" expansion of b). This changes the size of outstanding consolidated liabilities. It does so because it is an incremental source of funding for the government. It is an incremental source of funding because it finances a transfer payment or tax rebate to some subset of taxpayers. The instrument of financing (currency) is also the medium of exchange (currency). This is a deficit financing transaction, because government expenditures (i.e. transfers or tax rebates) have increased and have been funded by the issuance of a consolidated liability.

The core quantitative easing transaction (QE) is the central bank’s purchase of government securities. This has the effect of increasing broader money supply (M1) as well as bank reserves in the form of increased clearing balances held at the central bank. On a consolidated basis, the purchase of government securities reduces liabilities and the issuance of additional clearing balances increases liabilities. So the core QE transaction changes the composition of outstanding consolidated liabilities without increasing their size. Therefore, it is a pure balance sheet transaction that does not finance government expenditures on a net basis. Therefore, it does not finance the type of transfer payment or tax reduction that HM does. However, it does allow the government to issue more debt to restore market held debt to its previous level, which would finance HM type expenditures. On that basis, quantitative easing frees up “capacity” for the issuance of additional market debt.

So it’s really the effect of QE in freeing up capacity for the issuance of more market held debt that is comparable to the financing effect of HM.

But what I was really thinking of originally was skipping a step, or combining two steps in one depending on how you look at it, by considering the QE mechanism as a purchase of newly issued government debt. This single transaction would monetize new expenditures in a fashion comparable to HM, once the newly created government cash is distributed to taxpayers. It would have the same ultimate monetary effect as the two step process, but probably wouldn’t be as effective in the sense of providing an interest rate signal to the market.

Tricky stuff.

So you are right. What I was trying to say is:

HM = QE + bond-financed one-time transfer payment

Or, as I originally intended:

HM = QE where the bank buys newly issued bonds and finances the same one-time transfer payment

Either way, the essential point I was trying to make is that both QE and HM are mechanisms for the non-conventional expansion of consolidated financing channels.

[Bill Woolsey]

In my view, maintaining a target growth path of nominal income is the goal. And so, implicit in that goal is a target growth path for the price level. (Stable is my preference.) So, I am especially interested in how quantitative easing can offset reductions in velocity once the cental bank has reached a zero bound on its interest rate target.

Second, once it has already failed, so that the price level has fallen below target, how does quantitative easing bring nominal income and the price level back up to target.

If velocity is expected to rise again, back to "normal" levels, then it would seem obvious that the quantitative easing will need to be reversed. This would both be in the situation where it works "perfectly" and in the situation where if failed, but then works to move nominal income and the price level back to target, and still, needs to be reversed.

It seems to me that this is the relevant issue. If quantitative easing works by pushing the price level above the target growth path, and worse, does so by convincing people that the new monetary regime is that we print up money and give it away to the voters-- then it is worthless.

[Nick Rowe]

Bill: we need QE in circumstances where expected future PY has fallen relative to the target path (assuming we had one). In implementing QE, we announce that future PY will rise relative to where people currently expect future PY to be. If we are successful, expectations of future PY will be revised upwards, which means at least part of the increase in MV, relative to expectations, is expected to be permanent.

I don't think QE requires pushing P above the target growth path. I see it working by pushing P above the expected growth path, which is below the target growth path. So we are pushing P back up to the target growth path.

(Except, in Canada we have an inflation target, not a price-level path target, and it's not the same, because it validates past failures, and ensures QE will be temporary, and in the US you don't even really have the inflation target.)

[Scott Sumner]

Nick, A couple questions:

1. You say the government has to promise not to raise future taxes to make the helicopter drop work. But why should anyone believe those promises? The whole argument for the helicopter drop is that ordinary OMOs have failed. But Krugman tells us that ordinary OMOs will only fail if they are perceived to be temporary--if the public doesn't believe central bank promises to make the monetary injections permanent. But if that's the case, if the public doesn't believe the central bank, why would they believe the government? Or did I misinterpret your argument?

2. (The following is a general question--not directed at your post--which I agree with.) I'm not sure why people see QE as such a big problem. Has there ever in all of world history been a case where the public didn't believe a central bank's sincere promise to engage in QE until they hit their inflation target? I know of no such case, and doubt the problem would occur. If Bernanke announced that the Fed was going to keep buying bonds until inflation expectations rose to 3%, I might not believe the exact number, but I would certainly expect him to carry through until the nominal/indexed bond spread reached at least two percent. And some of your commenters are worried about overshooting toward hyperinflation. How can that occur if the Fed targets the forecast? It's not like one day the indexed/nominal bond yield spread is 2% and the next it's 100%. Are the fears of hyperinflation based on backward-looking monetary policy? If so, then I might agree.

[Nick Rowe]

Scott:
1. I think you might have misinterpreted my argument. One way to *define* a permanent increase the money supply, introduced via helicopter drop, is to assume that the government guarantees that taxes and government spending will not change, and assume that people believe those guarantees. I wasn't saying that government guarantees are more likely to be believed than central bank guarantees. Also, I expect I could have made exactly the same distinction between a temporary and permanent OMO. It's just I find it easier to think in terms of the distinction between a temporary and permanent helicopter drop.

Hmm. But I expect your point could be that some of what I said about central banks' balance sheets could be wrong if I were talking about an OMO rather than helicopter money.

2. I still have not gotten my head clear on targeting the forecast. The potential paradox of self-reference still bothers me.

My worry about inflation overshooting is based on the fear that people will believe the policy will fail, so the central bank does more QE,....and then people will suddenly change their minds. Confidence is self-reinforcing. I would be less worried if the central bank bought stocks, rather than bonds (see my latest post).

[federal st]

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US-Notenbank

Zur Stützung des amerikanischen Finanz- und Immobiliensektors will die US-Notenbank zusätzlich eine Billion US- Dollar (770 Mrd Euro) in die Märkte pumpen.

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"Die Federal Reserve wird unter den gegebenen Umständen alle verfügbaren Mittel einsetzen, um die wirtschaftliche Erholung voranzutreiben und Preisstabilität zu gewährleisten", hieß es in der Mitteilung der Notenbank nach der Sitzung des Offenmarktausschusses.