Monetary Policy’s Strange New World

There’s an old adage in economics that the best way to cure deflation is to drop money from helicopters. Clearly, this phrase isn’t older than mid-20th century, because before that time we didn’t have helicopters… we also didn’t have manipulative central banks. Now we have both, and they are about to join forces.

The helicopter statement isn’t meant literally. It conveys how central banks approach an economy when mainstream – and even out of the mainstream – monetary policies have failed.

There’s an old adage in economics that the best way to cure deflation is to drop money from helicopters. Clearly, this phrase isn’t older than mid-20th century, because before that time we didn’t have helicopters… we also didn’t have manipulative central banks. Now we have both, and they are about to join forces.

The helicopter statement isn’t meant literally. It conveys how central banks approach an economy when mainstream – and even out of the mainstream – monetary policies have failed.

By all accounts, central banks from the euro zone to Japan fit this description, and our own Federal Reserve is getting closer every day.

When the financial crisis first hit, the central banks did what they always do. They lowered interest rates. The goal was to entice borrowers to take on more debt, which they would arguably spend on goods and services, thereby giving the economy a positive jolt.

We all know what happened next.

It didn’t work.

A main reason, which seemed just as obvious at the time as it does today, is that developed economies weren’t suffering from a business cycle recession; they were suffering from a balance sheet recession. It wasn’t that the current expansion ran out of steam. It was that borrowers simply ran out of borrowing capacity.

As consumers – mostly homebuyers – we’d taken on all the debt we could and then some.

The long list of bad actors and schemes, including shadow banks, mortgage mills, derivatives, NINJA loans, etc., were all set in motion to feed the desire of regular people to get in on the casino money that was flowing from real estate. Where else could a work-a-day, $50,000 per year Average Joe put down a little cash (or even no cash) and walk away eight months later with a $20,000 profit?

The feeding frenzy drove entire industries, like home building and furniture. However, it couldn’t, and didn’t, last. The basis for the growth wasn’t earned income; it was borrowing, which eventually reaches a limit, even when it’s extended by sub-prime lending and predatory practices.

So lower interest rates in the face of a false expansion did nothing to revive the animal spirits of the economy. When that didn’t work, the Fed turned to monetary policy number two: printing cash.

Now, to be clear, I understand the Fed doesn’t “print” anything. It agrees to take bonds from Fed member banks, and in exchange adjusts the member bank’s account to a higher number. This one-sided transaction is the magical way the Fed creates capital.

In doing so, the Fed expected newly flush banks to make gobs of loans, creating new credit that would chase goods and services. The result would be economic growth, falling unemployment, rising wages, and a return to economic utopia.

They pledged $1 trillion. It didn’t work. Therefore, they slated another $600 million. Still no deal. Therefore, they did the contortionist dance called Operation Twist, which had no effect, and eventually decided to spend “whatever it takes.”

If that sounds familiar, it’s because ECB President Mario Draghi used those words to describe his approach to the euro. Whatever it takes. Remember that, it’s important.

It wasn’t just the Fed and ECB, central banks around the world were following the same script. They had to create inflation. They had to create growth.

Yet, they couldn’t. They haven’t. The problem is that both of these massive moves – in interest rates and cash creation – were focused on new loans. However, the original problem of a balance sheet recession, which stems from too much debt, was never fully addressed.

In addition, while many people did pay off their loans or go through bankruptcy, they’d be idiots to run up the credit cards and take out mortgages at the same rate as before. The only people crazy enough to suggest such moves are good ideas are… central bankers.

With interest rates below zero in many places and umpteen trillions of new dollars, yen, euro, and other currencies sloshing around the system, it’s about time for a new approach.

Central bankers have taken on the role of chief economic manipulators, and so far, they’re failing miserably. That makes them quite cranky after such a long run of success in the 1990s and early 2000s.

Which brings us to the next phase. Helicopters. Big ones.

I’m talking hulking, tank-carrying, supply-wielding monsters that blot out the sun, or at least any light that shines from reasonable decisions on currency management.

Regardless of whether they contain euro, yen, or eventually dollars, the reason will be the same.

They’ll drop their payloads on consumers for the express purpose of being spent.

Imagine the sight. It could look like something out of the war in Iraq, where pallets of shrink-wrapped $100 bills are parachuted to the ground in supply drops for distribution to warlords.

Or, it might not be as dramatic. It could take the form of “social assistance,” where central banks fund payments to low-income citizens, knowing that such cash has the greatest chance of reaching a retailer in short order.

It’s unlikely that this next phase will be any more successful in establishing solid economic growth, but it will do something. It will cement the idea that central banks really will do “whatever it takes,” even when that means taking more from savers, in any form possible, just to accomplish a dubious goal over which the bankers were never given authority in the first place.

“Whatever It Takes.” The Next Level of Monetary Policy is republished with permission from Economy and Markets Daily