Because QE at the zero lower bound is a form of maturity transformation, it is not particularly inflationary, and the many who believed it would be were simply wrong. Of course, in cases where central banks buy up private instead of government debt, the effects are larger, because this amounts to subsidizing select private-sector entities and creating actuarial liabilities for taxpayers. This kind of “fiscal QE” undoubtedly played an important role during the response to the financial crisis. But in most advanced economies, the emergency fiscal powers delegated to central banks were not intended for routine use in picking winners and losers, which itself can lead to a political backlash.
Dousing the Fire
This brings us to central banks’ third primary challenge: managing financial crises. There are plenty of good reasons why central banks should have emergency powers to buy up certain types of private debt or to guarantee financial-sector balance sheets, as the Fed did at the height of the 2008 crisis. After all, monetary policymakers have several short-term advantages over their fiscal counterparts.
For starters, in most countries, central banks can act quickly and decisively without having to pass legislation. Second, as regulators, they already have a close relationship with – and deep knowledge of – the financial sector, which makes them faster on their feet. Lastly, central banks tend to have considerable financial and technical expertise already on hand (though this is not necessarily a structural feature).
Most outside observers have praised the major central banks for their use of quasi-fiscal powers to manage the initial consequences of the 2008 crisis – and of the 2012 crisis in the case of the ECB. Yet monetary policymakers’ success in preventing a wholesale collapse of the banking sector nurtured the expectation that they would shepherd the recovery through a long period of sluggish growth that was all too typical after a deep financial crisis. Since then, the persistence of ultra-low interest rates has introduced severe constraints. Whereas normal recessions usually demand interest-rate cuts of five percentage points, most models indicate that systemic financial crises require cuts double that size.
Of course, other measures are available to support a post-crisis recovery, including fiscal stimulus and policies to promote debt write-downs, such as for subprime mortgages in the US and periphery countries’ debts in the eurozone. Fiscal stimulus can take the form of debt-financed government spending and tax cuts, but it can also take the form of redistributive policies that favor low-income individuals with a high marginal propensity to consume. Compared to normal monetary policy, however, fiscal policy is a blunt instrument that always comes with political baggage. In the US, a Democratic government would pursue stimulus through a massive increase in government spending, whereas a Republican government would do so through tax cuts.
Spinning in Place
Owing to these complications, fiscal policy is simply less wieldy than the policies that well-designed independent central banks can offer. But that makes central banks’ inability to inject stimulus at the zero lower bound an even more pressing problem. Worse, most of the ideas for restoring monetary-policy effectiveness involve transferring fiscal powers to the central bank, thus raising issues of democratic accountability.
A prime example is “helicopter money,” whereby the central bank issues currency (or bank reserves) and transfers the revenue directly to citizens. It is remarkable how many serious commentators – even leading financial newspapers – have endorsed this idea in one form or another. Yet while one can imagine scenarios in which helicopter money would be welcome, central banks lack the authority to distribute or redistribute income directly to ordinary citizens. That right is reserved for legislatures, and if central banks were to trespass on it, they would quickly be reabsorbed into treasuries.
Besides, there is a perfectly valid and legitimate way to achieve the same effect as helicopter money: the legislature issues debt to finance income transfers, and then has the central bank buy up the debt. (In fact, insofar as this amounts to helicopter money, the BOJ has been doing it for years.) But, again, if the legislature cannot agree on the shape or size of the transfers, there is little the central bank can do about it other than complain. At any rate, the effect of helicopter money would be nil unless central banks can credibly raise their inflation targets, and it is not clear that they can.
Another dubious idea with surprisingly widespread support is to have a central bank that is stuck at the zero bound buy up and then destroy government debt. But this, too, would most likely achieve nothing. If a wife gives her husband a loan and then tears it up, there is no effect on the household’s assets. Moreover, were the central bank to destroy debt owed to it by the treasury, investor concerns about internecine government warfare could lead to higher inflation. If the central bank ended up technically “bankrupt,” the government might make recapitalization conditional on higher inflation, or it might simply reabsorb the bank into the treasury.
If these nonsensical proposals are the best options on the table, it is safe to say that central banks currently lack the instruments needed to fight deflation, let alone increase inflation, in the event of a crisis. That is a problem for many reasons. Unexpected inflation provides a simple, time-tested mechanism for reducing the real value of private debts. If the Fed had been able to raise inflation to, say, 4-5% in the years after the 2008 crisis, the lingering private-debt problems would have been much more manageable.