Apr 15, 2019

How to Respond to Recessions

A Macro Musings Transcript
David Beckworth Senior Research Fellow , Eric Lonergan

Eric Lonergan is macro hedge fund manager, and economist, and a writer. He has written for Foreign Affairs, the Financial Times, and has authored the book Money (The Art of Living). More recently, Eric has also co-authored a new book called Angrynomics. He joins the show today to talk about how to improve policymakers’ responses to recessions. David and Eric also discuss helicopter drops, dual interest rates, and how governments can make monetary policy more direct.

David Beckworth:Our guest today is Eric Lonergan. Eric is a macro hedge fund manager, an economist and a writer. He has written for Foreign Affairs, the Financial Times and has authored the book *Money* and more recently has co-authored a new book called *Angrynomics*. Eric joins us today to discuss how to improve policy makers' response to recessions. 

David Beckworth: Eric, welcome to the show. 

Eric Lonergan: Great to be with you David, thank you very much. 

David Beckworth: It's a real treat for me because if any of our followers on Twitter know, we've interacted there before, we've interacted in the blogosphere, we've had some long exchanges and I was reading some of your posts in preparing for the show and I really like how you acknowledged that you learn from some of these exchanges because I know I do. I've learned a lot over the past decade coming out of the great recession, including from you. Learned a lot about helicopter drops, which we'll talk about later. It's fun to actually have this in-person chat with someone- 

Eric Lonergan: I share those sentiments absolutely. I find your writings fascinating to read and the exchanges and I'm one of the people who find Twitter and the blogosphere very productive. I've learned an awful lot and met up and engaged with very, very interesting people. 

David Beckworth: It's a great time to be alive for people like us, I really believe that. Twitter has opened a universe to folks who care about ideas and progress. So, great to have you on the show and I do this with all my guests. I ask them this question I'm going to ask you. How did you get into macroeconomics? What is your journey into it? 

Eric Lonergan: It was interesting. I guess I started with an interest in politics, which was really as a teenager. I was growing up in Dublin in Ireland in the late '70s, early '80s and it was a very, very interesting time. My parents were both academics at the university in Dublin. My father was a scientist, my mother was an Italian scholar and we had loads of academics coming through. People from South Africa. 

Eric Lonergan: So there were lots of political debates. It was a very religious upbringing. Ireland was a very Catholic society at the time and I was very influenced by debates about religion and ethics and morality but there were also issues happening in Northern Ireland that were kind of very specific to the Irish political environment, which I think has affected me and informed how I think about things. But also you got a backdrop of the Cold War, Apartheid in South Africa. All of these issues, I became very interested in politics and questions of ethics. 

Eric Lonergan: And funnily enough, I started reading Marx because of the Cold War so I wanted to understand what was this thing, Communism, and I think I concluded at quite a young age that Marx was a great diagnostician. His diagnosis was very insightful but his prescriptions were disastrous and it was through reading Marx that I realized how important economics was because Marx pretty much said everything's about economics and so I wanted to study economics. 

Eric Lonergan: Then, I got a chance to study at Oxford in the early 1990s, to do politics, philosophy and economics and I was very interested in moral philosophy, political philosophy and economics and really I found an amazingly fertile ground. I think I was very lucky because both in Oxford but also the state of economics at the time was very eclectic so I had a huge amount of freedom. I read anything from continental philosophers to Hayek, Friedman. I was given complete freedom in terms of what I could read and study. 

Eric Lonergan: That was really it and then at some point I came across [inaudible]. There was a fork on the road where I could either have gone into academia or into the private sector. By some sort of accidents, I ended up in the private sector and I found ultimately markets gave me both a different perspective, they allowed me to pursue my intellectual interests. But I just found very challenging as an economist because it's a very different form of empirical feedback, which in a sense you have to be pretty humble and if you're wrong, you're kind of out of business. 

Eric Lonergan: Ultimately, I found that a very fulfilling place and I was still able to engage with policymakers and with academics. That's kind of really been how I got involved in economics. I love economics. I still find it incredibly enjoyable, there's a limitless capacity to learn but also it's so relevant to our societies, our political environment, our social environment. 

David Beckworth: Very interesting. You're the second market participant or active practitioner from Wall Street or in your case from London and what's interesting, you both made this observation that unlike academics or people like me at a think tank, you actually have to think carefully because it affects your bottom line. You can't just engage in academic debates and on one hand, on the other hand ... You actually have to make thoughtful decisions, get real feedback. Markets are very disciplining so it's interesting to hear that. That, I think is great in terms of informing your debate. 

David Beckworth: Alright, Eric, let's move to the great recession and the policy responses that happened. We had both monetary policy, we had fiscal policies, some things seemed pretty radical at the time but we didn't have a great recovery. Can you give us your diagnosis of what happened in those two areas? 

Eric Lonergan: Yeah. To me what's fascinating about it is it was really a kind of controlled experience because ... And I think it vindicated what I would view as high school economics. Not even undergraduate economics. 

Eric Lonergan: When I was studying macroeconomics at high school, I was taught that when you have a recession you ease fiscal and monetary policy. It's really as simple as that. And I was taught both Friedman and Keynes and I was ultimately, by very pragmatic teachers, told there should be some kind of a synthesis so you cut taxes, you increase government spending, you have automatic stabilizers which do that automatically but you increase that and you also cut interest rates to increase money supply and increase lending because the economy needs nominal demand. 

Eric Lonergan: It was as simple as that. I was taught that for my high school exams in economics and I would say that was absolutely vindicated and it was vindicated because we saw China, which was the most successful policy response, which was huge fiscal and monetary stimulus. If anything, the fiscal stimulus was too successful in China because it then left them with some difficult consequences to deal with subsequently. 

Eric Lonergan: If we look at the developed world, the United States pretty much followed orthodoxy. We can argue about the magnitude but it was a big easing of fiscal policy and aggressive easing of monetary policy and then I think it was most muted in places like Europe and then the error became an attempt to, particularly on the fiscal side, restrain in the European case to go with outright austerity. But also, they made a massive error on monetary policy, which was not to engage in QE. 

Eric Lonergan: And I know a lot of people forget this but it's a critic ... To me the really big failure of the mind and to some extent the unforgivable failure of the mind was actually more in Europe than it was in the United States. I think you can be forgiven for having a slow recovery where we look back in hindsight and said broadly you tried to do what you could within political limitations and the limits of monetary policy. And you probably did everything about as right, given the information you had at the time. I mean, there was undoubtedly people calling for a larger fiscal stimulus and that probably would have helped but I think I would forgive US policymakers in the context of the counterfactual of how well the policymakers behaved. Albeit, you and I can come onto it. I think there's things they could do and that we should learn to do in the future that can help, A, avoid it, and B, make recoveries much more rapid. 

Eric Lonergan: But I think in Europe, there was a cardinal sin, which is ... And I know this as a market participant, is because the ECB in 2009 explicitly rejected quantitative easing when the rest of the world was doing it, they actually precipitated a run on their sovereigns and then they created a vicious feedback loop, which was first of all they said actually, these sovereigns are now a credit risk, whereas market participants had viewed them like every other bond market as being interest rate risk up until that point. And then if you make them credit risk and you impose austerity, which actually initially and maybe even into the medium term causes your credit position to deteriorate, you actually create a vicious feedback loop, which is why Europe has been such a disaster. Because effectively you had two profound financial and economic shocks. The initial, a banking crisis, then a sovereign crisis, which I think permanently impaired the European economy in a very damaging way. 

David Beckworth: Yeah, that's a good point. As disappointing as our recovery was, it could have been far worse like across the Atlantic. I wonder though, you mentioned the failure of the ECB to take on QE in 2009 early on like the Fed did and then austerity but I also wonder to what extent just the outright explicit tightening by the ECB ... So in 2008, they raised interest rates and then 2011 they're barely out of the woods, their recovery, if there is a recovery, is barely taking a hold and they raise rates twice. They signal more tightening. How consequential was that? 

Eric Lonergan: I think very. I think there's a couple of major errors of analysis that the ECB engaged in. Again, I think people have forgotten a lot of this discourse. You may remember first of all the ECB was saying that America had a bigger public sector debt problem than the eurozone did because they treated the eurozone as an aggregate fundamentally missing the point that the market could see that the Fed was buying up America's debt. 

Eric Lonergan: So somebody like me who looks at accounts can go, hang on a minute, how can I have a debt problem if effectively the net debt that's being issued is being hoovered up by the central bank who's creating reserves, which aren't really a liability in any meaningful sense, in which sense the net assets of the U.S. government actually aren't shifting very much and not only that I have no credit risk because the bond market is underpinned by the central bank with a printing press so we view bond markets as interest rate expectations plus or minus a term premium, whereas then I look at Italy and I'm told the ECB doesn't believe in quantitative easing and then we started to look into the legality and we're going, is there a legal problem? If these guys aren't backed by the central bank in a deflation, they're at credit risk so the CDS spreads start widening and before you know it there's a sovereign run. 

Eric Lonergan: So that to me is really one critical, analytical error they made was missing this link between the ability to create money and issue currency, underpinning the government bond market in a very clear way. I think there was an error about inflation risk so they thought the QE that America was engaging in and if you go back and you look at what Trichet says, it's by implication, he was saying he thought America was going to have an inflation problem, which was a colossal error. An error which I think was identifiable ex ante. 

Eric Lonergan: And in addition to that, I think they actually didn't realize there was going to be a sovereign panic, which is why the irony is, if you go back to June '09, they could have done QE under the guise of hitting their inflation target and they would never have had any of the legal problems. The legal problems arose for them later because they then allowed a sovereign panic to emerge. The problem is, if you start intervening as the ECB during a sovereign panic, the legality of your interventions are much more questionable- 

David Beckworth: Interesting. 

Eric Lonergan: Do you see what I mean? Because European law very explicitly says if they don't have market access in a sense you're engaging in direct lending or at least it's ambiguous and debatable whereas if they'd acted earlier there was no question. They could have bought the bond in the secondary market, Greece had market access, Ireland and Italy had market access, Spain, Portugal. So it would have been entirely defendable on a conventional… 

Eric Lonergan: I think there's one other point that's important, which people have forgotten in this is that the ECB actually had a kind of inferiority complex against America so they were constantly trying to differentiate themselves. It was almost as if we're going to do it differently and there was a kind of implicit criticism of what the Fed was doing and I think sadly that was a big source of their problems. 

David Beckworth: Yes, I remember in 2008, Trichet, you mentioned him, he was the president of the ECB during the early part of the crisis and with all due respect, one of the worst economic leaders during this time. He had this big celebration. There was a ten year celebration of the eurozone. If you look at his speech, it was very upbeat, everything's great, everything's wonderful, look at us, all these Americans have said we shouldn't have created the eurozone, look at us, we've got this incredible experiment full steam ahead. And of course, that's when things began to unravel so very untimely celebration there by him. 

Eric Lonergan: Hubris. 

David Beckworth: Hubris is a great word. It’s interesting to watch. So we have these monetary policy innovations occurring during this time and I want to get real specific. How effective do you think quantitative easing or large scale asset purchases are? There is a lot of economists who say, yeah, in the case of the US it lowered long-term yields about one percent, others question that but I guess at the end of the day, how effective in the current framework, the current setup is QE for a deep recession. 

Eric Lonergan: Okay, one of the things I find very frustrating about this debate is I think you've got to ask yourself what your problem is because QE's effectiveness is entirely contingent on the problem you're trying to solve, so I think early stage QE was hugely effective because the problem was actually a shortage of reserves and major problems with bank funding in the inter-bank market where banks didn't trust each other as counterparts and there was a genuine shortage of liquidity. 

Eric Lonergan: If you can imagine a demand curve for reserves, if you have a huge shift in the demand for reserves, the central bank has to create reserves in order to bring down money market rates and actually take control again of interest rates and QE is a very reasonable way of doing it. 

Eric Lonergan: Of course, there's nothing unconventional about it. Again, if I go back to high school economics, I learned about open market operations and they didn't make too much of a distinction as to whether you buy a one month, three month bill or a ten year bond. So, I thought QE was very conventional and absolutely the right thing to do, which is the system there was a structural increase in demand for reserves. There was reasons why the money markets weren't functioning so you'd blitz the system with reserves and liquidity. That's entirely appropriate and it was life-saving. 

Eric Lonergan: In a European context, I think it should have been done and it would have solved a different problem which is it would also have underwritten the sovereign and it may have done that. In other words, had we not done QE, there may have been problems in sovereign bond markets. We don't know. Markets might have worried about budget constraints or about too much government debt but given the demand for safety assets and the fact that central banks were buying government bonds, you certainly didn't have any budget constraints on the sovereign. 

Eric Lonergan: To that extent, I think QE was both vitally important and hugely successful. The point I make about QE is the marginal return diminishes very rapidly. As soon as you stabilized interest rates and regained control of money markets, it became a pointless exercise in my view. In fact, Friedman makes this point in his '68 AER address and I think he's absolutely right, which is that they become substitutes and again, for a participant like me in the bond market, it's pretty obvious to me you're just swapping one asset for virtually an identical other asset. So, QE just becomes a signaling device so you can have just as much effect or more effect by saying, "I'm going to keep interest rates low for three years." Then you can shift the Fed funds rate and you can affect the three year expectation of the Fed funds rate. So, I'm very skeptical about the subsequent effect other than purely signaling lower interest rates for longer so I think it was effectively noise, an awful lot of the QE. 

Eric Lonergan: I also think, what's happened with the term premia, we don't know the counterfactuals. Again, as an investor, I had been arguing for ten or 15 years and we'd been expressing it through portfolios for a huge reduction in term premia because of the risk properties of government bonds, which is that government bonds are actually insurance companies against recessions so you shouldn't get paid term premia in the first place in which case, and that's a consequence of low and stable inflation. So, we don't know if that was just secular trend of a reappraisal of the risk properties or the assets. It might have had nothing to do with QE whatsoever. 

Eric Lonergan: To cut a long story short, I think QE would have been hugely beneficial and ultimately, in the context of Europe and it's worth talking about it, when Draghi did QE, it kind of brought the sovereign crisis to an end so that was hugely important that he did QE. I think the initial QE in the US, in the UK and in other parts of the world was highly effective but I think its marginal benefit diminished very rapid. 

David Beckworth: I agree with that and to be fair, in full disclosure, I was a big champion of QE2, QE3 at the time but looking back, in the case of the U.S., QE1 was the area where it made the largest impact because there was a liquidity crisis. Markets were freezing up and that was an intervention and I wouldn't have done it the way the Fed did it but it was an intervention that did act as a lender of last resort in that role but afterwards, I completely agree. QE2, QE3, the marginal impact didn't seem to me to be as effective. 

David Beckworth: With that said, the Fed has said it will probably use it again going forward, so we're going to talk about that. It's interesting your point about how QE would have served a different role, different function in the ECB and that makes complete sense as well given the unique setup over there. One other thing the ECB has done, I would like to hear your thoughts, that the US or the Federal Reserves did not do; and that is turn to negative interest rates. What's your sense on how effective they were? 

Eric Lonergan: I'm very skeptical that they're beneficial so effectively, my view on interest rates is that the effect of interest rates on demand is not linear and doesn't have a staple sign. What does that mean in English? If you're in Brazil and you have ten percent real interest rates and you cut ten percent real interest rates down to five, you're likely to cause a huge increase in demand for durable goods and for areas of capital expenditure and you get a kind of obvious consumer investment spending response to a shift in real interest rate structures. 

Eric Lonergan: I think, however ... If you look at the theory of it, there is the substitution effect and there's an income effect. That's how it's supposed to work. The point is you can't establish theoretically that a reduction in interest rates necessarily causes a stimulus because to put it in simple terms, when you reduce interest rates, in principle, it's netted out because there's somebody earning interest income and there's somebody paying interest and so there's an equivalent gain and a loss and you end up becoming dependent effectively on the price effect or the marginal consumption. So if we transfer income away from the saver towards the borrower we have to kind of assume that the borrower has higher marginal consumption. So, that creates a stimulus. Or we have to think there's some kind of behavioral change by all agents, which is because my return on savings diminishes I now bring forward my consumption and I consume today. 

Eric Lonergan: When you apply that to the real world, it becomes very contingent and I think it becomes contingent on levels of debt. It becomes contingent on the process of intermediation. So, actually it's not obvious that you get a pass through ... When interest rates get very, very low and debt levels are quite high and consumption per capita is quite high and you have a very, very strong desire for savings, I think you can get perverse effects both through the intermediation channel but also how households are actually behaving. 

Eric Lonergan: So, I'm skeptical for example that when you get down towards a half percent interest rates or zero, that anybody is constrained on the borrowing side. In other words, I think it is more likely that borrowing is somehow being rationed by the banking system or is being affected by the bank's perception of its profitability. Most credits that want to take on leverage have access to leverage but I think the impact on people's savings can be quite dramatic and particularly when you look at societies like Europe when a lot of people are actually using interest income and thinking about interest income and they are concerned about rising healthcare costs, increasing longevity. All of those demographic factors. 

Eric Lonergan: If I combine that ... Then I would just again, this is as a market practitioner, we can make these subjects very difficult to pin down empirically, very difficult to answer theoretically. I can also then just look at how share prices respond. So we can have a debate about how it affects banks but I can observe what's happened to bank share prices and I don't see how it can be a good sign for an economy if when you go to negative interest rates, bank prices fall by 30 percent, which is what happened in Japan. So I again ultimately go to the fact that, I've got a market test here and I would listen very carefully to what that market is signaling. 

David Beckworth: Those are probably the two big innovations ... There's a third I guess, forward guidance. But the big, I think, innovations were the large scale asset purchases, the negative interest rates. We've had forward guidance before but those two ones are probably the most controversial at least and again, I think we both agree and many other observers would agree that the recovery in the US was disappointing. Yes, it was better than in the eurozone. So, we needed to look for some other way to make a more robust recovery and you have a solution. You got two solutions. One that I think you're better known for than the other. One that, that's how I came across you, and that's helicopter drops. 

David Beckworth: You've had pieces in the Financial TimesForeign Affairs about it. Explain to our listeners, what is a helicopter drop and how is that different than what the Fed, the ECD and the Bank of Japan are already doing? 

Eric Lonergan: Okay. The idea of helicopter drops actually originated ... If I try to find a historical case for it, again I would refer to Friedman 1968 AER rather than Friedman's famous paper on helicopter drops which is largely an illustration of how money can create inflation. In the AER paper, he's really using it to justify the fact that monetary policy can always work and I actually think he's right. 

Eric Lonergan: The simple version of it is, effectively the idea that the central bank makes a cash transfer to the private sector. The obvious case would be to make a transfer to households. And in the proposal that I and others have made is you would simply have central banks empowered to make the cash transfer directly to households instead of changing interest rates. And that would be financed by an increase in reserves and if there was an interest rate consequence that they were unhappy with, that you would either change reserve requirements used to get reserves, or use open market operations or an IOR to maintain the level of interest rates that you thought were appropriate. 

Eric Lonergan: It's an incredibly simple idea. You could argue it was effectively done by George W. Bush because arguably combining QE with tax rebates amounts to the same thing. The only difference here is an institutional one, which is, instead of relying on the government of the day or the political machinations, you can just empower the central bank to do it itself. 

Eric Lonergan: I should say there's another variant of helicopter drops, which I personally find a very unhelpful development which is the idea which was put forward largely by academic economists which is that you would have a permanent increase in the monetary base. We can talk about that if you want to. I think it's a bit of a non-starter personally because I think it's very hard to define and I largely think it's a fix for models rather than a real world solution but the real world solution is yes, you would just give central banks the ability to transfer money to households and in fact, I think there is now one central bank that has pretty much said they would consider doing this, which is the Czech Central Bank, which has pretty much written a paper saying, "We think actually, if we were to get a recession at this point, that's what we'd do." 

David Beckworth: Are they empowered to do that? 

Eric Lonergan: That's an interesting question. I don't know if it would require legislation. My conclusion, when you look at the legislative environment is this is going to depend by jurisdiction. In my opinion, the irony here is the central bank that has the most latitude is in fact the ECB. What's really intriguing about the European Central Bank is it has simultaneously very clear restrictions on what it can do and also a huge amount of freedom as long as it doesn't breach those restrictions. 

Eric Lonergan: If you look at the law governing the ECB, under no circumstances is it permitted to directly finance the public sector. These ideas like Adair Turner has proposed or Bernanke has proposed of overt financing where you print money to finance public expenditure, that is illegal. Unambiguously illegal in the eurozone. However, when it comes to effectively monetary operations, the ECB has worked as long as it is pursuing price stability and not financing governments, it can pretty much do whatever it wants. 

Eric Lonergan: So, I think there's a very simple way they could do it and actually, to your point about the biggest innovation in monetary policy since the recession, I actually think it's a thing called a TLTRO, which is these T-L-T-R-Os is the acronym, which the ECB have designed and I think that is the biggest innovation since the financial crisis and I can explain to you why. 

David Beckworth: Yeah please do, explain it to our listeners. 

Eric Lonergan: Because the TLTRO is effectively loans that are made by the European Central Bank to the banking sector, which can then be passed on to the private sector with a targeted loan, where they actually instruct the nature of the loan. 

Eric Lonergan: So far, those have been kind of vague and ambiguous. They're done at subsidized interest rates and there's a kind of formula by which the banks are making incremental new loans but here's what they could do. Let's say the ECB says we're going to do a trillion euros of perpetual TLTROs, so they have infinite maturity at a zero interest rate and they would instruct the banks ... They pay the banks an admin fee so say you get paid five basis points for administering it and every adult citizen in the eurozone is eligible to take out one of these loans up to a limit of whatever it would be. 2000 euros or 500 euros. And that could be done quarterly, for sake of argument. 

Eric Lonergan: That to me is legal. They have the means to do it. It's not breaching ECB law, which is because you're not directly financing the activities of government. You're using the banking system and you're making a transfer to the private sector in order to pursue price stability. But that's effectively to all intents and purposes a helicopter drop. 

Eric Lonergan: I think in most other jurisdictions, certainly in the United Kingdom, the bank of England doesn't have the kind of operational capacity to do this so there would need to be legislation but I don't think that's hugely controversial in the sense that to me it's very plausible that a UK government just proposes to parliament in emergency circumstances we are going to give the Bank of England this power. We as parliament are going to determine the distribution so we're going to say it's an equal transfer to all households and the Bank of England decides how much and we give them the means to administer it. 

Eric Lonergan: Obviously, on other jurisdictions, it will depend. I don't think the Fed would be able to do it under current law and Bernanke has proposed alternatives, such as the Fed actually effectively, the Treasury would set up a sort of special account, and the Fed would transfer effectively base money financed cash to this Treasury account, which the government in America would then decide how best to distribute that either through tax rebates or through government expenditure but in fact, to be honest, I think if you're going to legislate, you might as well legislate to give the central bank the power to do it directly and make the transfers. 

David Beckworth: Okay so central banks would directly send funds to individuals or households and this provides a way of critiquing what's being done now, and that is the Fed targets one interest rate and hopes to affect asset prices which indirectly affects spending and broader money creating by banks and it's also kind of a particular fiscal policy which has its own challenges the way it's currently done. This kind of cuts to the chase, right? This goes straight to the source of the problem. Households and let's give them the funding directly. 

Eric Lonergan: Absolutely. I've done a lot of thinking and work on the distinction between fiscal and monetary policy and what I find fascinating about this is it's an area where economics is entirely un-rigorous and has been very poorly thought out so I had this discussion with ... I went to a conference that Ben Bernanke was speaking at in Washington a couple of years ago and then I had a chat with him afterwards whilst he was eating. I sort of collared him because everyone else had gone. I thought, here's my chance to talk to Ben, so I'm going to take it. 

Eric Lonergan: And it was kind of everything I was suggesting. He said, "That's all fiscal policy." I said, "You need to be very careful saying that because that's what the ECB is already doing, that's what the bank of Japan is doing. If you say it's all fiscal policy, it's illegal in Europe." And I remember saying to him, "What is the distinction between fiscal and monetary policy? I've given this quite a lot of thought." And he kind of pondered for a bit, and it was clear to me, to be perfectly honest that, first of all he hadn't given it that much of a thought. What is precisely the distinction between fiscal and monetary policy? And I also found his answers to the question very unsatisfactory because in essence, everything that he said was fiscal about it, I could say was also true about existing monetary policy. For example, if you think about distributional consequences, look at the distributional consequences from changing interest rates. There are fiscal effects but there's a big difference between a fiscal effect and a fiscal policy. 

Eric Lonergan: Actually, how we spend our money as individual has fiscal effects. If I spend it and I pay taxes on it, that has a fiscal consequence. That doesn't mean my spending is fiscal policy. And I actually think probably the economist who was clearest on this was Friedman. Friedman pretty much said monetary policy is anything that involves base money. The control of base money is monetary policy. I think there's then an institutional dimension. Monetary policy is defined but institutionally and whether or not it's about the production of money. And then fiscal policy is kind of about everything else that the government does with taxes and spending. 

Eric Lonergan: I think economists are extremely loose about this. They will go, "Hang on a minute. What you're saying is fiscal policy. Define fiscal policy for me." And in Europe it's defined by law so what I'm saying is legally not fiscal policy because it's crystal clear that if it's done by the central bank, if it involves base money, is the objective is target price stability and it involves no treasuries, I mean no fiscal authorities, it's monetary policy. If it involves financing government activities, it's very clearly fiscal policy. 

Eric Lonergan: So, I think economists have to do some honest soul searching here because I don't think they ... It's a bit like when if you say to an economist we should increase reserve requirements, they say that's a tax on banks. Well, that's not fiscal. It's analogous to a tax but ultimately, the definition of a tax is almost a legal definition. That's not a tax, that's monetary policy. If you look at the institutional history of monetary policy, it's a bit like is an IOR a transfer or is it an interest rate? 

Eric Lonergan: We can have some very interesting debates about those but I think we do need to be clear that there's a distinct thing which is monetary policy and a distinct thing that is fiscal policy. They're distinct if it involves the monetary base, makes it monetary. And they're also distinct legally and institutionally and that is the crux of a lot of these discussion debates. 

Eric Lonergan: If I can make one other point, I also think as economists we would benefit hugely by doing a pros and cons of fiscal and monetary policy and this is a lot of what drove my thinking on this because to me there's some very clear advantages that monetary policy has over fiscal policy and some clear advantages that fiscal policy has and we need in a sense a synthesis of the two. 

Eric Lonergan: The advantages that monetary policy has is we can have a meeting this afternoon or the Fed can meet this afternoon and make a policy change. You can't really do that with fiscal policy, can't change fiscal policy every week or month as stances change. There's also much bigger in a sense consensus, so it isn't politically very ... I mean, it's contentious but not nearly the political ideological divide that there is with fiscal policy so there really is an absence of sense of fiscal. There's much more common sense in monetary. 

Eric Lonergan: Monetary is much more rapid response. The weakness that monetary policy has up until now is that it works indirectly. In other words, if you're saying, "I'm doing QE because I want to boost asset prices, and then I boost asset prices going to change the cost of capital to firms, it's going to change the wealth effect to consumers, that's an indirect effect." Fiscal policy, if I do a tax rebate and I boost your income, it boosts your income, that boosts consumption. 

Eric Lonergan: My solution to this is, let's try make monetary policy more direct. Don't take away its advantages by saying we need some kind of monetary fiscal coordination. That'll be a disaster. Let's take advantage of the ability to make decisions quickly in an apolitical way but let's give central banks tools where they impact incomes and demands in a much more direct fashion rather than indirectly through asset prices and leverage. 

David Beckworth: Okay. You are proposing an innovation to monetary policy, in short. Let's make it more effective, let's make it more direct and in the case of the US, I can imagine as you just outlined that the Federal Reserve starts depositing dollars in IRS to send to Eric to send to David to send to our listeners if there's a recession going on and they needed to do that. What are the objections you get? What is the pushback? Beyond you're confusing fiscal with monetary policy, are there any concerns that you get from central bankers, from other commentators, why we shouldn't do this? 

Eric Lonergan: There's a couple. Some of which I think are less valid than others. The obvious concern that a lot of people will make is about an inflation risk. Although that's less I think from economists because economists realize now that increasing the monetary base isn't inflationary in the kind of circumstances that we're talking about. I think people have just completely reassessed their views but certainly when you talk to non-economists about it, that's a concern. 

Eric Lonergan: The other concern that you get more from economists is about losses on the central bank's balance sheet and again I find this a very intriguing one because I really do think it's spurious at two levels. It's spurious because central bank's balance sheet in terms of its equity really doesn't matter. And this is a kind of accounting problem with central banks because Reserves aren't ... Money is not a liability. Cash and bank reserves in any meaningful sense. Treating it as a liability and looking at the bank's balance sheet and saying, for example, that there's negative equity doesn't really matter. What does that means to laymen is just there's no circumstances in which the central bank isn't going to be able to make a payment because they can create reserves. 

Eric Lonergan: Simultaneously, I think you can cut to the chase in terms of if you have a problem, can you ever have a problem of too many reserves. That problem, of course, can arise under any regime. It's got nothing to do with helicopter money. The Fed could find itself in a situation where it's got too many reserves. I don't think you can now because you can either use reserves requirements, you can use prudential measures, you can use tiered interest rates and you can use the IOR so I don't see a scenario where a central bank has too many reserves, so that really isn't a problem. 

Eric Lonergan: Then I think the problem comes down to ... I should also say that the point about central banks making a loss, if QE is successful, in a sense QE should generate a loss to the central bank because if I buy bonds at current market prices in order to stimulate the economy and it's successful, I should actually expect prospective interest rates to rise, which means I should make a loss in my bond portfolio. 

Eric Lonergan: That hasn't been the case except for the latest QE. The bank of England has lost money, some of the ECP has lost money and some of it, it's QE. But that's incidental. The point is, if it's successful, you should lose it. Why are people okay with a contingent loss but not a guaranteed loss? That's just silly. You've got a larger contingent loss versus a smaller guaranteed loss by virtue of not having an asset when you do the helicopter drop. So, that to me really is a spurious, un-rigorous criticism. 

Eric Lonergan: I think the most valid one is a political one. And I think this is even true in the case of the ECB so even though legally the ECB could do what I could call TLTROs for the citizens dividend via TLTROs, or TLTROs for everybody by making these perpetual loans at zero interest rate, which is effectively giving cash to European households, I think there is a concern that there'd be a political backlash, particularly because people would be confused about it and it might be difficult to explain politically what you're doing. 

Eric Lonergan: And I also think in jurisdictions there is going to be a need to legislate and that's going to need explanation both to politicians and are they comfortable giving central banks that kind of power, but I think that's a debate that needs to be had. I think the circumstances are sufficiently urgent that we need to address it. That kind of political opposition is something that we should tackle. 

David Beckworth: That's very interesting and it would be really fascinating to see the ECB try it first given the set-up it already has in place. Interesting conversation. You have a second solution. You've already touched on it I believe. The dual interest rates idea. Maybe quickly tell us what that is. 

Eric Lonergan: Okay, this has come out from two things. Partly, I got thinking about this because of what the Japanese have done with tiered reserves, which is effected at different interest rates on different classes of reserves, which I think is a big innovation. But also because of these TLTROs that I spoke about that the European Central Bank is doing. 

Eric Lonergan: If you imagined a central bank ... The ECB now has two interest rates. It has an interest rate on reserves, which are the deposits that banks make with the European Central Bank, but then it also has an interest rate when it lends to the banking sector under the TLTRO program. We realize that a central bank can have two interest rates and you can think of this as the interest rates on our deposits or savings and the interest rates on our loans. 

Eric Lonergan: I've had a lot of debates with Miles Kimball about this. You're familiar with his work and he's done a huge amount of work on it and he's a big advocate of negative interest. I think there is a kind of synthesis of where I've ended up agreeing with him is I said, let's say I could do this with interest rates. I described previously a world where we had one interest rate and the problem with one interest rate is if I reduce it, my savings income declines in proportion to the fact that the interest rate on your borrowing declines so the net effect is zero. What if I had two interest rates, one on loans and one on deposits, and if I say I'm going to leave the deposit rate positive. Let's say I'm going to pay you about half a percent of your deposits but I'm going to start making your borrowing rate negative so I'm going to separate the two interest rates. 

Eric Lonergan: A commercial bank can't do that, obviously, because they would just be losing money. They would have negative interest income. They'd be paying depositors and they'd be paying borrowers simultaneously. But the central bank can do that because the ECB can do that now. The ECB suddenly has two interest rates. To me, it's obvious how you stimulate. Which is the whole problem with negative interest rates is the fact that savers are losing income, but the ECB can actually go, "You know what? Let's have a zero deposit rate, so we're going to bay zero on your reserves to the banking sector, but we're going to charge a minus 1.5 percent on the loans we give you." 

Eric Lonergan: These loans are not unlimited and you can't just take the loan and put it on deposit and kind of round trip, make yourself money as a bank. You have to use these loans to fund investment spending or mortgages or consumer spending. All of a sudden, I think they've got a monetary bazooka. I have not met anybody who can explain to me how that isn't a dynamite stimulus. 

Eric Lonergan: It's not totally dissimilar to helicopter money. It's just actually using your existing institutional framework over which to do it because you are making a cash transfer to the private sector. You're not making a cash transfer to households, but you are making a cash transfer to the private sector. 

David Beckworth: One question I had about it was the threat of arbitrage which you kind of addressed earlier. You said that you would have to take those loans to the households to lend them out. But the concern that I would have would be arbitrage. Someone would borrow at that low rate then deposit it. But I also begin to think, maybe that's the point. If the central bank gets caught in an arbitrage loop, isn't the bank creating money for the parties arbitraging it. Wouldn't that be a stimulus too? 

Eric Lonergan: It would. The reason why you want to try, and avoid an arbitrage or a naked arbitrage. They've been pretty successful with TLTROs that I think you can monitor it. I think it starts to become pretty obvious if you're borrowing from the central bank and putting it on deposit. I think you have to make the extension of new loans and you specify what the terms are. They've been able to do that with huge TLTROs. They've done a huge amount. 

Eric Lonergan: The key point, I think, is the point of the power of two interest rates and this is why, I think, the TLTROs are an extraordinary monetary innovation because there's another thing that's really interesting if you contrast it with the QE is the marginal impact increases. It doesn't diminish. When we talked about QE, both you and I agree, initially huge impact then its impact diminishes. The thing about these TLTROs is if you keep cutting that interest rate and extending the maturity, it becomes dynamite. 

Eric Lonergan: Can you imagine if you're offered a loan at two percent minus two for 15 years? Initially if you said I’m going to do that at minus 40 basis points for three years, which is kind of what they've already done, that's not so big. But you keep on doing that it starts to become very powerful. 

David Beckworth: That's a great point. In both of these proposals, the helicopter drops and the dual interest rates, you tie these ultimately into managing nominal demand directly. You know I'm going to ask this question. Would you like to tie these tools into a nominal GDP level target? 

Eric Lonergan: I certainly don't have a problem with it. In terms of the target for me, I tend to think more in terms of the labor market but I think that's probably has much to do with my background, labor economics originally. But I'm quite relaxed about the nature of the target. I certainly think inflation targets are largely redundant because I think there's no inflation and I think there's good structure or reasons for that. 

Eric Lonergan: I think we are operating in the world of price stability which Greenspan described as one in which private agents just don't pay any attention to the aggregate inflation rate. They view everything as relative price changes. I kind of think we're there, in which case we're almost pretending to inflation target and we don't really do it anymore and I actually think the Fed is kind of coming around to admitting that. 

Eric Lonergan: The idea of having very stable or stable growth in nominal GDP seems to me to be entirely reasonable but I wouldn't sacrifice ... If I saw rising unemployment but I was meeting my nominal GDP target, I would raise my nominal GDP target. 

David Beckworth: Okay, so you wouldn't directly target nominal demand. This is one way to do it. But you would be flexible on how you do it. You mentioned your concern about labor. One interpretation of a nominal GDP target, it's also called a nominal income target so you can loosely think of it as targeting the average wage so there are ways to frame it I think that would be consistent with what you hope to do. 

David Beckworth: Okay Eric, in the time we have left, I want to move on to an article you wrote that was titled fixing the eurozone and reducing inequality without fleecing the rich. You touched on helicopter drops in there as well, but what you get to that's kind of novel and interesting is the sovereign wealth fund idea and you get into this and you talk about the equity risk premium and you mentioned this earlier when talking about government bonds. Kind of connect it all for us. Why sovereign wealth fund and why is the equity risk premium such an important idea to it? 

Eric Lonergan: Okay. The crux of the issue is I'm sympathetic to the idea that we need to do something about wealth inequality and specifically that there's large portions of our society that don't have access to assets and that their lives could be dramatically improved if they had savings and financial assets. 

Eric Lonergan: I think there's a political consensus emerging globally that we have to do something about wealth inequality. The problem is we don't have practical policies. We either have policies that require a high level of global coordination that isn't going to happen but also there's huge political obstacles to it in terms of getting a political consensus. 

Eric Lonergan: We tried to come up with an idea that didn't involve raising taxes and the solution to me is a very intriguing one, which is all of us economists have been slightly frustrated because if you're sitting in the UK, for example, where you have negative real interest rates for 20 years, negative real bond yields, the UK government can effectively get paid to borrow in real terms for 20 years and yet government haven't been doing infrastructure spending. You could make the same debate in the United States. You look at how low 30 year Treasuries are. You barely got a positive real interest rate. Why isn't the government doing loads of infrastructure spending with a positive real return? 

Eric Lonergan: The problem is, I think even Larry Summers can see to this, is you try doing the infrastructure so even where you have a political consensus in the UK that infrastructure is a great idea, we can't actually get it done or it takes you decades to agree it and approve it and administer it for it to take effect. There's a much simpler solution, which is why not use your financing to acquire assets and create a sovereign wealth fund. 

Eric Lonergan: Really, what I'm drawing an analogy between is it's like discovering oil. Having a negative real interest rate as a sovereign is like discovering oil so what you could do is you could effectively do the equivalent of a Harvard endowment where the government puts ten percent equity, it issues government bonds for 90 percent and it acquires assets and it puts it out to tender, gets some private sector to manage it and says, "Generate me a six percent, seven percent real return," which is very doable if you buy global risk assets. And then in ten years’ time, based on those expected returns, I should have effectively doubled the value of my assets. My liabilities are pretty much constant because of where real interests are, I can repay the debt and I've effectively got assets in a sovereign wealth fund and then I can distribute it to those parts of society who don't have assets into funds which they could then draw down for specified purposes. For example, health, education or training or retirement. 

Eric Lonergan: You've got a means whereby the government can use its balance sheet to effectively create value. There's an interesting question as to why we've got that balance of cost of capital but that is how assets are currently priced and that seems to me to be a very reasonable way where one could tackle wealth inequality in an innovative way that's kind of outside of current political debate, which makes it a much more effective policy proposal. 

David Beckworth: Tell us how the equity risk premium plays into that. You've alluded to it but just for our listeners' benefit, what is the benefit risk premium and why is it consequential to your argument? 

Eric Lonergan: Okay. The equity risk premium is the excess return that you obtain as an investor by taking on the risk of the stock market versus so-called safety assets, which would be cash and bonds. One of the things that I think economists are very poor at is when we talk about interest rates we kind of imply that interest rates are the cost of capital but we don't actually pay that much attention and distinguish between different types of costs of capital. 

Eric Lonergan: Firms and individuals don't borrow at the Fed funds rate and firms usually look at an equity cost of capital when they're considering a project that has risk and there's been a huge difference. We've had this collapse in global real interest rate structures but actually, if you look at the pricing of global equities, it hasn't moved very much so it's very normal in the context of history. 

Eric Lonergan: What does that mean? That means if you buy the MSEI world equity market, so if you just take an index exposure to global equities, you should earn something like a six percent, seven percent real return. Of course, there's no guarantees that you do so you could be prudent and say, let's just assume I make a four percent return. It's pretty diversified and as I extend my time horizon and the probability of me generating that four percent return becomes more likely and the state can do that. The state can take a ten, 15 year view. 

Eric Lonergan: That's the equity risk premium, the fact that the state can borrow a close to zero real over a 15, 20 years, it can buy assets that should generate between four percent and 8 percent real return. If it succeeds in generating those returns, it can then retire its debt and its created national wealth and then it can distribute them. That's the functional role the equity risk premium can pay and I think this has arisen. It's a totally unintended benefit from having no inflation because one of the consequences of no inflation is that the central bank cuts interest rates at the first sign of trouble which is another way of saying that government bonds become insurance policies against recession and I think that's one of the reasons why the private sector has such a strong desire to own government bonds in this world of low inflation. 

Eric Lonergan: The fact that the government is the kind of monopoly issuer of insurance policies against recession is kind of like a benefit. It's kind of like manna from heaven that's handed to the government and that we're not really taking advantage of but we could take advantage in this innovative way to try, and tackle wealth inequality. 

David Beckworth: How would it work in terms of detail? You mentioned government would create this fund and then outsource it to private fund managers. What are the operational details? 

Eric Lonergan: I think that's probably the right way to do it, which is you set up ... It's going to be an independent authority so you've set up a sovereign wealth fund, you have to have oversights and you have to have an independent board of oversight. The legislature will legislate the rules so you broadly say what its objectives are and I would express them as a return objective and you literally set it up like an endowment and it would work in the same way. It would certainly be staffed like any other government agency. It would have oversight like a government agency that has oversight, and then it could absolutely mandate the third parties subject to that oversight that they are ... In the same way that a university endowment or a charitable endowment hires the private sector to run the assets for them for a fee. 

Eric Lonergan: Then effectively I would finance at ten percent equity, 90 percent debt and I would make it big. I'm talking about 20 percent or 30 percent of GDP because the other point I think that's really important here is I think globally, and this comes onto the issue of the book, is I think there is a real problem in the center of politics which is there's a danger that politics is the public imagination has been captured by the extremes of politics and what's really needed are some new, radical ideas that can really change people's lives in a positive way but are in some sense non-partisan and I think this is the kind of policy that could be done at scale that is viable and could make a real different to people's lives. 

David Beckworth: Okay, very interesting. Our time is up and Eric, we're going to have to have you come back to the show to discuss your new book you've go-authored called Angrynomics. We'll have you back on in the future when it's released later this year but thanks so much for coming on the show, it's been a real treat. 

Eric Lonergan: It's been a great pleasure, thank you David, I really appreciate it. 

David Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app, and while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening. 

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