'Helicopter Ben' confronts the challenge of a lifetime

By Martin Wolf, Financial Times, 16 Dec 2008

Central banks may soon resort to their most powerful weapons against deflation: the printing press and the "helicopter drop" of money. It is a time for which Ben Bernanke, chairman of the Federal Reserve, has long prepared. Will this weaponry work? Unquestionably, yes: used ruthlessly, it will eliminate deflation. But returning to normality thereafter will prove far more elusive.

Mr Bernanke delivered a celebrated speech on the topic in November 2002, when still a governor.* He spoke quite soon after the US stock market bubble burst in 2000. Policymakers then feared the US might soon follow Japan into deflation – sustained declines in the general price level.

Yet Mr Bernanke then insisted "that the chance of significant deflation in the US in the foreseeable future is extremely small". He pointed to "the strength of our financial system: despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape". The words "pride" and "fall" come to mind. Six years and a housing-cum-credit bubble later, chairman Bernanke must be sadder and wiser.

Mr Bernanke's view was also that "the best way to get out of trouble is not to get into it in the first place". The fear that reversing deflationary expectations would prove hard explains why the Fed has cut its official interest rate so quickly since the crisis broke in August 2007.

Is deflation a realistic likelihood? Core measures of inflation strongly suggest not. But one measure of expected inflation – the gap between yields on conventional and index-linked?Treasuries – has collapsed to 14 basis points. Moreover, yields on 10-year US Treasury bonds are already where Japan's were in 1996, six years after the latter's crisis began. (See the charts, which start one year before respective asset price peaks.)

Why then should central banks fear deflation? First, deflation makes it impossible for conventional monetary policy to deliver negative real interest rates. The faster the deflation, the higher real interest rates will be. Second, as explained by the great American economist Irving Fisher in the 1930s, "debt deflation" – the rising real value of debt as prices fall – then becomes a lethal threat. In the US, whose private sector gross debt soared from 118 per cent of gross domestic product in 1978 to 290 per cent in 2008, debt deflation could trigger a downward spiral of mass insolvency, falling demand and further deflation.

Already, the Fed has adopted a host of unconventional actions to keep the economy afloat. By December 10 the Federal Reserve's balance sheet had reached $2,245bn (€1,663bn, £1,490bn), a jump of $124bn over a week and $1,378bn over a year. It held a wide range of government and private paper, including $476bn in Treasury securities, $448bn in "term auction credit", $312bn in commercial paper and $233bn in "other loans", which includes $57bn of credit to AIG alone. If it keeps going, the Fed may become the largest bank in the world.

Does it face any constraint? Not really. As Robert Mugabe has shown, anybody can run a printing press successfully. Once the interest rate hits zero, the Fed can perform much further easing. Indeed, it can create money without limit. Imagine what would happen if an alchemist could transform lead into gold, at no cost. Gold would not be worth much. Central banks can create infinite quantities of money, at no cost. So they can reduce its value to nothing without difficulty. Curing deflation is child's play in a "fiat money" – a man-made money – system.

So what might central banks do? They might lower longer-term interest rates by buying as many long-term government bonds as they wish or by promising to keep short rates low for a lengthy period. They might lend directly to the private sector. Indeed, they might buy any private asset, at any price and in any quantity they choose. They might also buy foreign currency assets. And they might finance the government on any scale they think necessary.

Alternatively, the fiscal authorities can run a deficit of any size they wish and then finance it by issuing short-term paper that the central bank would have to buy, to keep interest rates down. At the zero-rate boundary, fiscal and monetary policies become one. The central bank's sole right to make monetary policy is gone. But the reverse is also true: the central bank can send money to every citizen. This is the helicopter drop proposed by the late Milton Friedman and recently discussed by Eric Lonergan on the FT's economists' forum.

At this point, one might wonder why Japan has struggled with deflation for so long. I have little idea. But the explanation seems to be that the Bank of Japan did not wish to take such drastic measures and the Ministry of Finance did not dare to force the point. Such self-restraint will not deter the US authorities.

So will the Federal Reserve drown the world in dollars, whereupon we will be able to wake from the nightmare? As Willem Buiter shows in a recent blog, "Confessions of a Crass Keynesian", the answer is No.

Once inflation returns, the central bank will need to sell assets into the market, to mop up the excess money it has created in fighting deflation. Similarly, the government must reduce its deficit to a size it can finance in the market. Otherwise, deflationary expectations may swiftly turn into expectations of above-target inflation. This may also happen if the debt sold in efforts to sterilise the monetary overhang is deemed beyond the government's ability to service.

Countries without a credible currency may reach this point early. As soon as a central bank hints at "quantitative easing", flight from the currency may ensue. This is particularly likely when countries remain burdened under a huge overhang of domestic and foreign debt. Creditors know that a burst of inflation would solve many problems in the US and the UK. The US may manage the danger of resurgent inflationary expectations. The UK is likely to find it more difficult. Avoiding deflation is easy; achieving stability thereafter will be far harder.

Ironically, we are where we are partly because the Fed was so terrified of deflation six years ago. Now, a credit bubble later, Mr Bernanke has to cope with what he then feared, largely because of the Fed's heroic attempts at prevention. Similar dangers now arise with the drastic measures that look ever more likely. This time, I suspect, the result will ultimately not be deflation but unexpectedly high inflation, though probably many years hence.