What to do if the usual weapons fail

There are plenty of new policy responses for governments to turn to

Oct 11th 2018Print edition | Special report

FROM THE robots that help care for an ageing population to holographic pop stars, the future always arrives early in Japan. Economic policy is no exception. When the massive Japanese financial bubble of the 1980s imploded, the Bank of Japan (BOJ) struggled to respond. In 1995 short-term interest rates fell to near zero, presenting a headache the rest of the rich world would not confront until 13 years later.

In battling its “lost decade”, the BOJ tested many of the policies, such as QE, that would enter the toolkit of other central banks during the financial crisis. Yet Japan was seen as an example of central-bank incompetence, until smug Western central banks discovered after 2008 that getting an economy to perk up when interest rates were near zero was harder than it looked.

Since the election of Shinzo Abe in 2012, Japan has reprised its pioneering role. Mr Abe replaced the head of the central bank and promised to reflate the economy. The BOJ supercharged its asset purchases; its balance-sheet grew from about 40% of gdp in 2012 to 100% now. It bought not just government bonds but corporate debt, shares in equity exchange-traded funds and in property investment trusts. It announced a yield target of 0% on ten-year government bonds, in effect extending the rate control central banks have long exercised over short-term rates to very long maturities. Japan’s efforts offer just a sample of the unconventional tools available to governments when rate cuts and QE disappoint. When the next recession strikes, Japan-like interventions might mark only the first foray into an uncharted policy landscape.

Economists recognise the challenge that lies ahead. Since early in the recovery it has been clear that rates would probably be low, and debt loads high, when the next downturn arrives. The energetic discussion this knowledge provoked has ensured that there is a rich menu of options for policymakers to draw upon when a new slump arrives. It is not clear how eagerly they will reach for them. Politicians and central bankers have been remarkably complacent in preparing to combat a recession in a low-rate world.

The fiscal costs of borrowing during slumps might be significantly less than previously thought

Proposals fall into a few different categories. Many economists reckon it is important to try to salvage central banks’ traditional role in stabilisation by adjusting monetary-policy targets. The problem is the zero lower bound on nominal interest rates. The economy responds to the real rate of interest, which is the nominal rate (the one observed in the market) adjusted for inflation. For example, if the nominal rate is 4% and inflation is expected to be 3%, the real rate is roughly 1%. The higher inflation is, the less likely economies are to hit the zero lower bound, because a zero nominal rate corresponds to a lower real rate.

In the 1980s and 1990s, most economists concluded that a 2% rate of inflation struck the right balance between containing prices rises and avoiding the zero lower bound. Yet from the 1980s, the real rate of interest needed to keep economies from falling into a slump fell ever lower. According to work by Kathryn Holston, Thomas Laubach and John Williams, of the Federal Reserve, this “equilibrium real rate” has fallen from about 3% in America and Europe to below 1%. The cushion that 2% inflation provided between zero and the nominal rate thus proved to be too small.

There are a number of ways to fix this problem. One would be simply to raise the rate of inflation targeted by central banks. Some economists have mooted this as a possibility. Olivier Blanchard did so in 2010, as chief economist of the IMF. Laurence Ball, of Johns Hopkins University, has also advocated for a 4% inflation target. With a higher background level of inflation, nominal interest rates would be higher on average and the zero lower bound would bind correspondingly less often. On the other hand, firms and households would have to deal with a higher rate of inflation all the time. Where central banks have a strict price-stability mandate, raising the target might require a change in the law.

An alternative would be to target a trend-level of inflation rather than a rate. Should inflation fall below target during a slump, a level-targeting central bank would promise to allow faster-than-normal, “catch up” inflation in the future, in order to return the economy to trend. The expectation of that faster growth in future should boost animal spirits and help drag the economy out of a slump. The downside to a level target occurs when inflation accidentally rises too high. Central banks would in such cases need to deflate the economy back to the trend level, which would mean inducing a painful slump. To avoid that necessity, Ben Bernanke, now a fellow at the Brookings Institution, proposed in 2017 that the Fed should temporarily adopt a level target when the economy runs into the zero lower bound on interest rates. Then, the Fed could promise to return the price level to its pre-recession trend, making up for the shortfall induced by the recession, at which point it would revert to targeting an inflation rate.

Others reckon that inflation is the wrong target altogether. Monetary economists have long used nominal GDP (NGDP), or simply the total money value of all income or spending, as a proxy for aggregate demand. There are advantages to targeting NGDP instead of inflation. Inflation-targeting central bankers must try to guess whether an acceleration in spending will lead to an acceptable rise in real output or an unacceptable increase in inflation. A central bank targeting NGDP can remain agnostic on such questions. Further, for firms and households considering investment decisions or grappling with large debts, stable growth in incomes matters more than stable growth in prices. During the Great Recession, NGDP fell faster and more sharply than inflation. Though prices were relatively stable, households found themselves forced to pay bills with incomes much smaller than they had anticipated.

There is no time like the present to adopt a monetary target better suited to a world of low interest rates. Yet should governments drag their feet today, a change in target during a downturn could itself boost demand, by proving policymakers’ desire to revive the economy. In 2011 Christina Romer, of the University of California, Berkeley, argued that a switch to NGDP targeting could jolt expectations in a positive way, much as Franklin Roosevelt’s decision to abandon the gold standard did in 1933. She seems to have persuaded Mr Abe, whose pledge to raise incomes was a centrepiece of his economic reform package. But conservative central banks might be loth to change targets without political support.

Moving targets

While the Fed could argue that such a target fits within its dual mandate to promote both price stability and maximum employment, the ECB, charged with keeping prices stable above all else, has less freedom. Governments might set other targets of their own. Mr Blanchard and Adam Posen, of the Peterson Institute for International Economics, proposed in 2015 that Japan consider adopting an official incomes policy. The government could direct firms to raise wages by 5-10% a year. The resulting sharp rise in wages (and prices) could free the economy from its zero-rate trap, though firms may respond by curtailing recruitment.

Regardless of the official target, central banks could improve the potency of their asset purchases. They could condition QE on yields on long-term bonds (as the BOJ has done) or on other economic variables, like the unemployment rate. Such promises work by signalling a commitment to keep policy accommodative, even if inflation rises outside the central bank’s normal comfort zone. Central banks’ normal hostility to inflation can undercut efforts to boost a slumping economy, because firms and households fear that stimulus will be removed at the first sign of rapid growth. When interest rates fall to zero, central banks must therefore “credibly promise to be irresponsible”, in the words of Paul Krugman, an economist.

Of course, monetary policy need not carry the burden of recession-fighting alone. Prior to the financial crisis, mainstream macroeconomists were sceptical about the need for government borrowing to lift an economy out of slumps. It was assumed central banks could do the job, and fiscal stimulus would often come too late, too inefficiently and at too high a cost to government debt burdens.

The crisis upended this thinking. Whereas many analyses of government spending prior to the crisis concluded that $1 in government spending contributed less than $1 to GDP (or had a multiplier of less than one), estimates of the effect of fiscal stimulus and austerity during and after the crisis routinely found multipliers in excess of one: a dollar spent (or cut) had a disproportionately large effect on output. Most dramatically, an IMF analysis in 2013 by Mr Blanchard and Daniel Leigh estimated that fiscal consolidations after the crisis were associated with multipliers substantially larger than one, and thus placed a serious drag on growth.

The upshot of this work is, first, that fiscal stimulus is an important tool for fighting recessions. And, second, the fiscal costs of borrowing during slumps might be significantly less than previously thought. In 2012 Lawrence Summers of Harvard University, and Brad DeLong of the University of California, Berkeley, argued that, if prolonged unemployment threatens to reduce an economy’s long-run growth potential, then fiscal stimulus at the zero lower bound might well pay for itself. More recent work by Alan Auerbach and Yuriy Gorodnichenko, also of Berkeley, suggests that government borrowing during periods of economic weakness does not tend to raise long-run indebtedness or borrowing costs, even for countries with large existing debt burdens.

That still leaves the question of how to use fiscal stimulus. Given a prolonged slump, concerns about the timeliness of government spending become less pressing. Indeed, Mr Summers has argued since the crisis that near-zero interest rates may represent a new normal, requiring sustained fiscal stimulus, including support for investments in infrastructure and other public goods.

In a new paper summarising a broad set of analyses of stimulus programmes Jason Furman, a former economic adviser to President Barack Obama now at Harvard University, identified several key lessons from the crisis. While discretionary stimulus programmes—like the large, one-off legislative packages enacted in 2009—are economically effective, political systems seem to lose their appetite for such programmes rather quickly. A more sustainable approach then, would lean more heavily on automatic stabilisers: programmes which mechanically add to spending and reduce taxes when economic trouble strikes, without the intervention of a parliament. Large social safety nets already provide some automatic support during downturns: deficits grow as tax revenues decline and payments for unemployment benefits and other emergency outlays increase. This natural stabilisation is one significant reason that the post-crisis downturn was less severe than the Depression. More such features could be added, however. Taxes on labour could be linked automatically to the level of unemployment. In more federal systems, like America’s, central-government support for constrained local governments could also rise automatically as local economic conditions deteriorate.

Don’t be so negative

There is always the possibility of greater radicalism. Milton Friedman, a Nobel-prizewinning economist, argued that printing money could never fail to boost the economy. If necessary, the central bank could simply shower fresh banknotes on the economy as (he joked) from a helicopter. While a large tax cut funded by QE would accomplish something similar, governments could authorise central banks to manage cash handouts themselves.

This could be feasible were individuals able to bank directly with the central bank—a privilege currently reserved for banks. In a recent essay Morgan Ricks of Vanderbilt University and colleagues propose such a reform in order to improve consumer banking and financial stability. The accounts could also improve monetary policy transmission, they argue. In normal times, interest-rate changes would apply directly to the public’s deposits at the central bank, rather than through the banking system. When rates fall to zero, the central bank could use the accounts to deliver newly created money to the public.

Central-bank accounts, and central-bank money, might also enable central bankers to cut rates deep into negative territory. Though some central banks experimented with sub-zero rates over the past decade, few ventured far into negative territory. So long as holding cash (which has a nominal yield of zero) remains an option, negative rates can only be used sparingly, lest depositors take their money and run. Indeed, an analysis of negative rates post-crisis by Gauti Eggertsson of Brown University and colleagues found that banks generally do not reduce the rate paid on deposits below zero, presumably because they fear cash withdrawals. A radical monetary reform which replaced cash with electronic money could solve this. But sucking money from bank accounts might have unintended consequences and would be unpopular.

Roger Farmer of the University of Warwick reckons that animal spirits could be most effectively managed through stabilisation of asset prices, including stock indexes (like the S&P 500). Central banks could undertake this in places where they are authorised to buy equities or equity funds. An alternative would be to establish a sovereign wealth fund with the resources to buy and sell securities in order to stabilise wobbly markets: to unload shares when investors turn exuberant and buy in times of despair.

Recessions occur where there is too little spending to keep an economy’s resources from falling idle. Economists have spent the past decade thinking up ways to boost spending and escape recession when interest rates are at zero, as they almost certainly will be during the next global slump. But these proposals, while promising, are largely untested. Those which have been tried, as in the experiments in Mr Abe’s Japan, have delivered mixed results. Given uncertainty about how and whether experimental policies work, an effective global response to the next downturn will need to be bold, sustained and co-operative. It will hinge, in other words, on what political decisions are made. But if the menu of recession-fighting options is longer than ever, politicians have rarely seemed less eager to co-operate, across party lines or borders, to produce good economic policy.