Megan Greene and Eric Lonergan on Dual Interest Rates and the Prospects of Average Inflation Targeting

Megan Greene is a global economist and Senior Fellow at Harvard University School, and Eric Lonergan is an economist and macro fund manager at M&G Investments. Both Megan and Eric are returning guests of the show, and they re-join Macro Musings to discuss dual interest rates and the potential power it brings to central banks. Specifically, they discuss the current constraints on central banks’ toolkit, how the example of the ECB targeting TLTRO’s illustrates the potential of dual interest rates, why the concern over fiscal versus monetary policy is misunderstood, and whether the Fed’s new average inflation targeting mandate can be successfully implemented.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Megan and Eric, welcome back to the show.

Megan Greene: Thanks for having us.

Eric Lonergan: Thanks, David.

Beckworth: Yeah, it's great to get you both on. Now, Eric, you came on in early or April 2019. Megan I believe was March this year, so it's been a while since we've chatted. It's been six months or so since the pandemic has started, so how are you guys holding up?

Greene: I've just sprung myself out of the US and I'm sitting in London, so I'm doing better with a change of scenery, for sure.

Beckworth: Oh, okay. So you're both in London now?

Greene: That's right.

Lonergan: We even managed to have a socially distanced lunch over the weekend, so yeah. All is good.

Beckworth: Oh, fantastic. So you are both speaking to me from London, another testament to the wonders of the day and age we live in, where I can have conversations with people across the Atlantic. And I just did an interview with Robin Harding in Tokyo, which was great, other than the time differences. So it's fascinating to be able to talk with interesting people like you all across the world, and today we're going to talk about an article you have, it's titled “Dual Interest Rates Give Central Banks Limitless Firepower.”

Beckworth: I like that, because you're very optimistic about what central banks can still do. The premise of your piece is that the Fed and other central banks are not out of ammunition, and I love it because that really goes against the grain of much commentary, if not most commentary today. Everyone's kind of saying, "Hey, central banks have run out of ammunition," and I want to illustrate this with a piece that Greg Ip wrote from the Wall Street Journal back in March when this whole crisis was unfolding, and the title of his article is “A Misplaced Faith in the Power of Central Banks,” and I'll read the first few paragraphs.

Beckworth: It says, "Wall Street and President Trump have begged, admonished, and tweeted for the Federal Reserve to come to the economy's rescue. Tuesday morning, the Fed obliged. But their faith is likely to prove misplaced." And he goes on to say, look, we've reached the lower bound, the Fed can't do much more, it's time for fiscal policy to step in. The Fed is really on its last legs, so don't place your faith in the Fed.

Beckworth: But you guys say not so fast, right? You're pushing back against this, which is really, again, surprising, because most people who have come on the show, even, would take the other side of that position. So walk us through, why are we not at the end of the Fed and other central banks' ability to respond to the economy? You mention a number of tools they could still try, and ultimately dual interest rates, but maybe walk us through this. Why is there still more room left for central banks to respond?

Current Constraints on Central Banks' Toolkit

Greene: I would say, first of all, that fiscal policy would be great, so I'm in favor of that and would argue for that, but if it's not coming, largely because of political constraints, then I do think there is more a central bank can do.

Greene: You could do more QE, is one thing. Though now that I sit in academia, when I was in the private sector in asset management and everyone was in love with QE, they thought it had been fantastic, in academia, actually, it's widely viewed as a complete failure, and within parts of the Fed it's been viewed as either a failure or having had some fairly mixed results. So we could have more QE, but that's not necessarily a silver bullet.

Greene: We could follow in the steps of the Bank of Japan and engage in yield curve control, and up until the Fed changed its monetary policy strategy, it did seem like yield curve control was actually on the table. Investors were certainly hoping it was. One problem with yield curve control is it's really hard to stop once you start, so you're kind of stuck in forever, and we've seen that with the Bank of Japan. So that doesn't seem to be a silver bullet.

Greene: In the US in particular, we still have rates that are in positive territory, policy rates that are in positive territory, so that sets us apart from some other central banks. So in theory, we could just start cutting rates into negative territory, but there's this whole school of literature suggesting that that undermines the banking system. At a certain point, people just take their money out and stick it under the mattress, so you can only go so negative, so there's this effective lower bound beyond which you can't cut rates anymore, it actually becomes counterproductive. And the Fed has been pretty clear, they don't really want to do that. And that kind of leaves us with dual interest rates, which I'll tee up for Eric to explain.

Lonergan: Thanks, Megan. Okay, so I guess the genesis of the idea of dual interest rates, it really goes back three or four years, when the ECB announced sort of yet another program with a confusing acronym, in this occasion TLTROs, which most people on the planet don't know what they are, understandably, and not even that many economists understand what they are.

Lonergan: But effectively what these were, were funding programs but for banks. But what was innovative, in a sense, was that the funding program, it wasn't just about providing emergency liquidity, which has of course been a standard practice in terms of intervening in bank funding markets, i.e., lending to banks. But this was targeted lending, so it was actually trying to use funding of banks to provide a monetary stimulus sort of independent of the other tools of monetary policy.

Lonergan: And specifically what they did is they said, we're going to provide you with funding, I mean large scale funding, significant percentages of Eurozone GDP, contingent on you making net new loans, right? So they actually had a kind of balance sheet expansion criteria. And that is a big shift in policy, because suddenly, you move from viewing the funding side of your monetary tools as a kind of emergency liquidity to actually potentially being a source of stimulus.

Lonergan: Then, what struck me and Megan through time is they started to talk about the interest rate on this TLTRO, started to become a kind of independent discussion of the official interest rate, which is the interest rate on reserves, that's what American policy analysts would be familiar with.

Lonergan: And ultimately, at a certain point, it was striking. Well, why can't they just leave the interest rate on reserve unchanged, and just move to targeting this independent policy rate? And then all of a sudden you're freed from all of your issues and all of the problems of a lower bound and negative interest rates. And it's really as simple as that.

Lonergan: I actually think there's an element of accident in how this evolved, which is central banks have always had funding vehicles, so the Bank of England had a funding for lending, the Bank of Japan used one after Fukushima. So we've always had emergency liquidity. Somebody clever somewhere at one of these central banks thought, this could also be an independent stimulus, and then once it was out there we started to think, well, why not just keep cutting the interest rate on the funding scheme?

Greene: To be fair, when the TLTROs were first announced, they were widely viewed to be kind of emergency provision for the crap banks in Europe, so they were there for the banks that were really struggling, so they were this stimulus for them.

Greene: The point I think Eric’s just made that you can actually introduce a second interest rate. The TLTRO rate was the same as the deposit rate up until recently, actually. But they started specifying the TLTRO rate, and it made us realize, well, it doesn't actually have to be the same. So when a central bank cuts or hikes rates, they have to make allocation decisions about whether they're going to benefit savers or borrowers.

Greene: But if you actually have two rates, you can move them in different directions, and you can benefit both savers and borrowers at the same time. So that's a massive stimulus across the economy, and it gets rid of the effective lower bound, because you don't just have one rate that you're playing with. So you can go ahead and you can cut the TLTRO late, or the lending rate, really negative, so essentially the central bank is paying banks to borrow, as long as they pass the loans on to the end user, that's why it's targeted, and then the banks can go ahead and provide these loans also at negative rates if they want, so you create demand for those loans. Everybody's getting a bit of a stimulus in the process, and at the same time you don't have to penalize savers, because you can go ahead and hike that rate, you can hike the deposit rate. So you don't have to choose, in terms of allocation, you can actually benefit everyone.

If you actually have two rates, you can move them in different directions, and you can benefit both savers and borrowers at the same time. So that's a massive stimulus across the economy, and it gets rid of the effective lower bound, because you don't just have one rate that you're playing with.

Beckworth: So everyone's a winner with dual rates, which is an interesting point of this. Because as you mentioned, Megan, a lot of people do often point the finger at the central banks and say, "Oh, you're harming pensioners, you're harming savers." And I always push back against that by saying, "Hey, the neutral rates dropped. It's not really the central bank doing this, they're kind of following it down.” But what you're presenting is an even better response to that critique of low interest rates, that you still can respond to all segments of society.

Beckworth: And just to summarize what you said, you have a great line in your paper that says the ECB can target the rate at which banks can fund lending, or borrow from the ECB, independent of the rate at which the reserves are remunerated or deposited. So I want to unpack that in terms of the US. So let's say, for example, the Fed were to try this in the US, and maybe this will help some listeners, it definitely helped me think through what this is.

Beckworth: So in the case of the US, the lending rate would be to the discount window, right? The discount rate. Is that fair?

Greene: Yes.

Beckworth: So in the case of the United States, then, you would take the discount rate and lower it well below the interest on reserves. So right now, interest on reserves is .10%, so maybe you lower the discount rate to, say, -2, -3%. I'm just making numbers up here, but you would dramatically lower the discount rate. So banks could borrow at this incredible rate, but the conditions, as Eric said, is they'd have to lend into the real economy. But banks would still be able to find a place where they could earn something on their reserves and not be hurt by decreasing that interest margin. So is that a fair way to think of it in terms of the US?

Greene: Yeah, I think that's fair. It's very different from how things have been, right? The discount rate usually comes at a premium. So it would be rethinking that entirely. But that being said, in March, the Fed cut the discount rate more than it cut the Fed funds rate, to get rid of that premium. So in some ways, the Fed's sort of already taken a step toward setting up the plumbing for this.

Lonergan: Yeah, and just to clarify, because to be really clear about this, as Megan alluded to earlier, the European Central Bank, during this pandemic and crisis, they haven't reduced the IOR, right, they haven't tried to bring money market rates or the interest rate on reserves to a more negative level. They have only cut the TLTRO, right? So I think it is really important to be aware that that is effectively the channel, apart from the other programs that they're doing in terms of intervening in asset markets, but in terms of interest rates, they have elected not to continue to bring down the interest rate on reserves, but to bring the TLTRO, under certain conditions, to a lower level of interest.

Lonergan: The challenge obviously with the discount rate for the Fed would be what conditions do you attach in order to access this preferential funding, because the typical response otherwise would be, well, I can just borrow at the discount rate window and I hold reserves at the Fed and I just round tripping and it's just carried to banks. The European Central Bank has obviously thought that through very clearly, and so they've established quite rigorous conditionality.

Beckworth: Yeah, so banks wouldn't be allowed to arbitrage that difference, they would have to actually employ it in loans directed towards the real economy. So there would be conditions, but that is one of the critiques, I guess we could jump to that right now. I've seen some of the interactions on Twitter, some of the pushback is, "Well, this would quickly be arbitraged in the markets." And my response is, well, the Fed would say, "No, banks can't play this game." And then someone replied to me, "Well, what if someone else two or three levels downstream, what if they try to take the funds and arbitrage it. So how do you respond to that?

Responding to Critiques

Lonergan: First of all, I have to say, as somebody who works inside a financial institution, a regulated financial institution in Europe at the moment, I don't think, I think the culture's fundamentally changed now. I mean, most large financial institutions that would've accessed TLTROs live under the fear of their regulator. The idea that you would try to game the central bank who is your regulator, I mean, that is somebody on a mission to get into trouble, right?

Lonergan: Because the regulator in Europe has had teeth. I mean, the ECB and the European banking regulator is very, very tough. So that's the first point I would make, which is I don't think the banks are going to go out and try and game the system here. Now, there's absolutely no evidence that anyone is able to do it at the moment. The other thing that's worth bearing in mind is, of course, the quantity of reserves is determined by the central bank. No individual bank can determine how many reserves they hold. So it's often a bit of an illusion that reserves are created, and somehow I can take a loan and create reserves.

Lonergan: Well, you can't, because reserves are the function of what the private banking customers do, and it is the net result of it. So the distribution of reserves is not under the control of individual banks, it's the result of the activities in the private sector. Now, is it the case that, let's say the European Central Bank says, "Okay, we're going to provide a new round of TLTROs, and they have to be consistent with the commission's objectives that they go into sustainable energy." Is it the case that some projects that would've happened get financed? For sure. But then, the test I always put with any policy idea is, is it better or worse than your existing policy tools? The reality is, we have huge questions about the allocation of capital, and lots of challenge by just using low interest rate regimes that you might get a misallocation of capital.

Lonergan: So to me, the question here is do you want to provide stimulus, and do you have a reasonable sense that people aren't gaming the system at scale, and can you actually have a material economic impact? And on those measures, to me it's kind of unambiguously positive. At the margins, might you be substituting some kind of lending? For sure.

To me, the question here is do you want to provide stimulus, and do you have a reasonable sense that people aren't gaming the system at scale, and can you actually have a material economic impact?

Greene: Yeah, I think you get at a few other critiques that I hear about TLTROs. One is, "Well, you're just creating a misallocation of capital," so you're creating demands for loans that wouldn't otherwise exist, and sowing the seeds for the next crisis, and that might be the case. That's also the case with QE, arguably, and in the face of a deflationary spiral, those kinds of concerns tend to get moved to the back burner. So it's valid, but I think it depends on what you're facing. If you are facing a deflationary spiral, then you don't worry about that as much. So that's another critique.

Greene: I think there's another critique in terms of whether this is fiscal or monetary policy as well, because if you're providing a stimulus, should you really be doing that? Do central banks want to get into asset allocation? And the unequivocal answer is no, central banks don't want to get into asset allocation, but actually every decision a central bank makes affects asset allocation. Hiking or cutting a single rate, that affects asset allocation. So to some degree there's no way for the Fed or any other central bank to avoid this anyhow.

Greene: I would also say that the line between fiscal and monetary policy would be blurred with this, but it's already been blurred. I think we've already seen that central banks are acting more in the realm of fiscal-ish policy anyhow through this crisis, and I don't think that we're ever going back. So I think we're kind of there anyhow. And thirdly, I kind of say who cares whether it's technically fiscal or monetary policy. I mean, I think this is actually monetary policy, but if you want to say it's fiscal policy, that's okay. I mean, the Fed and other central banks are political actors, even if they're meant to be independent.

Beckworth: Yeah, well I want to come back to that question in just a minute, but one more critique that you mention in your paper, the two of you, is that some worry this might harm the balance sheets of a central bank. They might get negative equity, for example. And you guys try to explain and respond to that, but my first response is, "So what? That's what you want in a deflationary crisis," right? If the central bank takes the loss, that means it can't pull the reserves back in, it doesn't have the assets to do it, and that's exactly what generates spending, inflation.

Beckworth: Now, you want to do it in a controlled fashion, you don't want to just kind of willy-nilly and recklessly do this, but taking some kind of loss is actually the point of creating some inflation and demand for the economy, but do you want to speak to that critique?

Lonergan: I mean, I think that's a great point you're making and I couldn't agree more. I just want to make two points on this as well. I think when one thinks about the pros and cons of a policy innovation like this, you have to benchmark it against your existing policies. Right, so the hurdle here is not perfection. The hurdle here is, is this better or worse than our existing tools, more or less effective? So, for example, when people worry, I mean, as Megan alluded to, the whole issue of zombie companies or misallocations of capital because interest rates are too low, I would say it’s much better to target lending, right?

Lonergan: Keynes made the point, one of the reason Keynes said you should never raise interest rates to stop a bubble, he said is if you raise interest rates, the only investment spending that will happen is the one in the bubble sector, right? Because when you're in a bubble you think your returns are astonishing, so you don't care about the cost of capital, right? And so you can have very perverse effects. I would much rather you say, "Actually, we're going to cut interest rates now," but the funding, which is of a fixed amount, can only go, say, into fixed asset investment, right? You could exclude, so for example, the ECB excludes housing from TLTROs, which is very interesting. So arguably, TLTROs are a better way of using negative interest rates to prevent the kind of distortions in the allocation of capital or even asset price bubbles like in housing, because you can target them.

Arguably, TLTROs are a better way of using negative interest rates to prevent the kind of distortions in the allocation of capital or even asset price bubbles like in housing, because you can target them.

Lonergan: So I think that's an important point to bear in mind. Now, to the balance sheet point, you are absolutely right, and the way you put it I thought was very astute, which is you said you worry that you don't have enough assets to take back the reserves. The number of people who miss this fundamental point, because what you've described is, we can take two approaches to this. We can try and go through tortuous calculation, what is the capital and equity of the central bank? And I tell you, you and I can come up with whatever number we want, I mean that is a philosophical question. There's no accounting standards, because there's only one institution that can create reserves out of thin air, right?

Lonergan: So that's actually virtually meaningless to me in accounting terms. The simple question is, can I ever have too many reserves as a central bank? So in other words, can I ever create reserves that put me, then, out of control? So I've injected reserves into the system, and now I've lost control of monetary policy. And the first point to make here is that problem exists with all policies that we are currently operating with, right? So that problem exists with QE. In fact, it should be the result of successful QE. Because if QE is successful, the price of all of those bonds availed should fall, because in a sense, they've caused a stimulus by driving the price of them up and the yield down, so when the recovery happens, the yield should rise and the prices should fall.

Lonergan: So central banks are supposed to make a contingent loss of scale on their asset purchases. That, in effect, means, as you rightly point, the mark to market is very important, because they can't then reverse it. Let's say they then discover, "This has been too successful." Oh, but unfortunately, the price of all my assets has fallen, so I can't shrink the reserves by just selling ... So I've got exactly the same problem. But I've also got the same problem with an IOR, plain and simple, right?

Lonergan: So let's say I bought all these assets, and for sake of argument, ignore what happens to the asset price, but I've just got a problem. If I start raising IOR… the Fed funds rate, heaven forbid, in two years time was 4%, I've got negative net interest income, massive negative net interest income, because I created a huge amount of reserves. So the reality is, if you're worried about central banks' balances, you're worried about equity, if you're worried about negative net interest income, you should be really worried already and you should be stopping all of those programs, okay? That's definitely not a problem associated uniquely with dual interest rates.

Lonergan: But the final point, to me, and this is what's really interesting, and we haven't spoken about this yet, is I think tiered reserves are another fascinating and important innovation, because what they reveal to me is that you can always shrink the stock of reserves, because you don't need assets, right? So the point here is, you set an independent interest rate on required reserves, and excess reserves. Now, as soon as I have that as a tool, what I could do as a central bank in the future is I could say, "Okay, excess reserves determine money market rate," so I start raising them. But I could go into reverse on the required reserves. So if I want to shrink the stock of reserves, I'll just raise the required reserve limit and charge a negative interest rate on it, and they'll shrink.

Lonergan: The banking system, of course, will start to go backwards, because that will damage banking sector profitability very substantially, that will raise the cost of loans, cut the interest rate on deposits, and the system goes into reverse. So I personally think one needs to think about the future of central banking with these two new innovations, which is that you have targeted lending, and you have tiered reserves. And then, the issue of equity is spurious, because all that matters here is can I keep cutting the rates on funding, and can I shrink reserves if I have too many?

I personally think one needs to think about the future of central banking with these two new innovations, which is that you have targeted lending, and you have tiered reserves.

Lonergan: Apologies, I went on a bit long there, but you raised it very, very well, because you posed the problem in terms of the Fed running out of control of reserves, and I think that's a much more fruitful discussion than getting bogged down in calculations about how much capital central banks have.

Greene: This point on tiered reserves is really important as well, I think because central banks seem to be going in the opposite direction. So the Bank of England doesn't have required reserves and excess reserves, they just have reserves. And I am constantly asked, "Why does the Fed even have excess reserves? Why is it IOER? That doesn't make any sense, why wouldn't it just be IOR all the time?" So the trend seems to be in the opposite direction, but actually that would be wrong, because you'd be eliminating this useful tool.

Beckworth: This is great because I'm someone who's been a fan of corridor operation systems, the Fed has a floor, and that's kind of a popular thing now. But a tiered system is kind of a hybrid between the two, it's kind of a middle ground, and I hope we go in that direction for many of the reasons why I like a corridor system.

Beckworth: Let me go back one more time to this idea about protecting a central bank's balance sheet, because I do find it ironic, and I want to very clear to all our listeners, again, I'm not saying I'm going to go out and blow big holes in a balance sheet. This should be done in a controlled, thoughtful process for sure. But it does strike me that many central bankers sometimes care more about their balance sheet than their objective of stabilizing inflation and aggregate demand.

Beckworth: Where this really became clear to me was the Swiss National Bank, when they were pegging their currency to the Euro, they finally quit for one reason, they were afraid of losses on their balance sheet. And I was like, "Well, that's the whole point," right? That is the whole point. And I know they actually have shareholders and they've got to be concerned about some issues the Fed doesn't, but if you're so worried about your balance sheet, I think you're losing focus of what your first objective is. Again, I'm not suggesting we are reckless with the balance sheet, but we need to have a list of priorities in front of us starting with price stability, the dual mandate, stabilizing demand, and it just strikes me that sometimes central bankers get their priorities backwards.

Lonergan: The other thing I would just say here that I think is important is, and I have to do a bit of accounting in my day job, the problem is that you cannot apply conventional commercial bank accounting to a central bank. The way I look at it, it's worth reading Warren Buffett on this, when Warren Buffett, for example, talks about insurance companies, he analyzes their float. This has been a big source of his wealth generation, and he says is float really a liability or not? Because it keeps growing and it never gets called upon, right? So, in insurance terms.

Lonergan: Now, the point is if I could find the business that could literally, physically print dollars legally, what would its market cap be? I mean, how do you do a present value of that business, right? So the accounting is just, frankly, silly, right? It's just silly. We shouldn't even try to go there. They can always honor their liabilities in dollars. The only thing that matters is can they lose control of inflation or not?

Greene: Yeah, and central banks have run in the red before, the Czech National Central Bank, it's been in the red. So-called underwater central banks aren't like normal banks, so it's fine, it doesn't matter.

Beckworth: Okay, so we've gone through a number of criticisms and concerns about dual rates, one last one and we'll move on, and that is some folks say, "Well, you're just creating the supply of funding for new loans, but there's got to be demand for it." You're kind of pushing without the corresponding increase in demand, there needs to be demand and then demand and needs to move first, so how would you respond to that concern?

Greene: Well, I think you can create demand if you're offering loans at negative rates to users, and then they'd be getting paid to borrow, that could generate some demand. Do you end up making some loans that probably aren't great loans and maybe wouldn't have otherwise happened? Absolutely. So that's the misallocation of capital issue. But this, for decades economists have been saying central banks can only deal with supply issues, they can't really deal with demand issues. This is a way to deal with a demand issue.

Lonergan: Yeah, I also think, and this might happen with the ECB, I think it's probably trickier in the US context. But I would not be surprised if, and I think this is quite a clever approach, if the ECB were to link future TLTROs actually to a reduction in interest charges on existing loans. So far what they've done is they've said, you can have this, we're going to give you a negative interest rate on your funding, as long as we see evidence that you've made net new lending, so we can be convinced that you've created a stimulus, a monetary stimulus.

Lonergan: But what you could do is you could say, okay, let's say, we want your loan book, the average interest rate on your loan book to come down by 50 basis points, then you can access, or some formula. So in other words you could actually link it to a repricing of the existing loan book.

Beckworth: Yeah, that's a great suggestion. And Megan, going back to your point, I completely agree. The simple way I would summarize it is everyone has a price. At some point, you lower their interest rate enough, you said you pay people to take the loans out. At some point, if, for me, in the real world, it means the bank is going to pay me to take out a loan to get a new dishwasher, to remodel part of my house, I'll do it if they're going to pay me to do it, so you've just got to keep lowering that price until behavior responds.

Beckworth: And along those lines, you guys give specific recommendations for the ECB. You outline that right now, banks can fund lending at -1%, and reserves pay close to zero, but you say go all the way down to -4 if I read that correctly, is that right?

Lonergan: Yeah, that was based on some econometrics that Megan did I think, right?

Beckworth: Okay, Megan?

Lonergan: No, no I’m kidding.

Greene: It was just by way of example. I mean, the point being, lower it really significantly, the ECB has set up the infrastructure to do this. They've actually implemented it, but in a really timid way, and I think our point was you could do this in a much bolder way. And if you're looking at the Eurozone, which is experiencing deflation, you've got moves in the currency that means that the Eurozone's importing deflationary pressures now, this is one way to reverse that in a bolder way, so if you cut the TLTRO rate to -4% for example, but several hundred basis points more than the already do, then the effect would be even larger.

Greene: I will say, at Christine Lagarde's last press conference, she did say the take up of this TLTRO was significant and widespread and she thought that it had a major effect. So I think that there's some proof that this is working, but they should do it in a much bolder way.

Lonergan: And just to add to that, maybe, David. I look, again, in my kind of day job, if I look at say infrastructure, there's a huge amount of demand now from the investment community, which, given pension funds, given demography, of acquiring long-dated assets. If you look at something like our energy infrastructure, particularly say in Europe where a lot of end prices are regulated, so effectively regulators are determining how much the rate of return is. The real point we wanted to convey here is the private sector is typically, still in Europe, funding itself at a positive rate, it depends on their credit quality, but at a positive rate.

Lonergan: If you wanted to supercharge sustainable energy investment, if you made like five year, -4% interest rate loans available, if they cooperate with, in the European case, there is potentially more of a structure for cooperation where the guidelines of these loans could be specified by the commission, i.e. that they have to be, say, in certain, say green energy. I mean, if you said wind energy or other types of sustainable energy, where you can get a return of four or 5%. I mean, you would supercharge investment there if you suddenly made funding available at -4.

Lonergan: And it just reveals, you just suddenly realize that there's absolutely no limit here. I mean, so like, the only question is do you want to do it or not? Like, you can't say, "I can't hit my inflation target" because you clearly can. I mean, -10? And the other point that's really important in a European context, to this point about the depositors and the different interest groups, the other thing that's interesting here is one of the German constitutional court's objections to policies like QE and negative interest rates is precisely that it's placing this burden on depositors, so they are viewing them as creating a form of political tension or making decisions that are adverse. And there's been no objection, legal objections to TLTROs in the context of the Eurozone, which again is very interesting when we come out of the debate on fiscal versus monetary.

Beckworth: Okay, so it's a win-win, as you mentioned earlier, you've just been explaining, that savers benefit from this, depositors benefit from it. Everyone, borrowers and lenders, they all come out winners under this approach, so you'd think there'd be some political support for this. So how's this idea been received? You guys have both been on the case for some time now promoting this, and your most recent piece at Fox EU, so what's been the reception that you've seen from market participants to central bankers?

Greene: So the ECB's already doing it, so they’re fans. I would say the Bank of England is already doing it to some degree as well, or has done it, with its term funding scheme. If you talk to the Fed about it, they think it's an intriguing idea, but sort of give you the sense that it would be an intriguing idea if we were staring into the nuclear abyss or something, as an absolute last possible option to pull out, rather than thinking about using it a bit more proactively. And to be fair, we view the threat of deflation as a little bit less in the US than it is in Europe, our rates are a little bit higher, so maybe that's why they feel they've got more room.

Beckworth: So I guess my question, Megan, would be, though, is the ECB open to your suggestion of going even farther down with the rates? So you mention -4 as just an example, but are they open to the possibility going maybe -2, -3?

Greene: So I don't think that they're there yet, and that's why we've seen it implemented it in such a timid way. But they know the tools are there, certainly. They know that they've set this up.

Beckworth: Eric, have you heard anything from market participants, what they think about the idea?

Lonergan: The thing I'm most struck by is, and I'd be very interested to get your thoughts on it David, but my sense is there's a surprising lack of awareness. And I don't know quite whether this is by intention or not, but this was really a profound shift that the ECB has made this year. By setting the TLTRO below the interest rate on reserves, that is crossing a Rubicon. And, to be honest, I didn't expect them to do that, certainly not this quickly. But as Megan said, it was surprisingly, people just didn't realize it, because TLTROs are confusing. And so my main observation is that people are still getting their heads around it, that actually it's a very poorly understood innovation, although it's already happened.

Lonergan: And the reason I can tell that is there are certain obvious questions that the media should be posing, which is, first of all, why don't you just cut this rate a hell of a lot more? Because clearly you're not hitting your inflation target, and in Europe it's a mandate by law, that it is the mandate of the ECB. It's got a legal requirement to hit its inflation target, and it's failing. We're in a pandemic, we need much more stimulus, everybody would kind of agree that we need contingent stimulus, what aren't you discussing it openly? Why aren't economists doing calculations and working out what's the r* on a TLTRO? Why hasn't somebody gone away and modeled it, right? And then the whole debate would change, and I don't really understand why those conversations aren't happening.

Lonergan: So initially, you know the way economists work, but mostly they kind of go, "I haven't really thought about that," "Oh, that's just fiscal policy," or kind of that's a subsidy to the banks, they're going to arbitrage it. So you've had all the kind of initial instinctive and then people go away and think about it and I think suddenly sort of go, "Hang on a minute, actually, this is a big of a game-changer."

Lonergan: So that's my sense so far, and we'll see. I mean, I think were things to worsen, in the case of Europe ... Oh, one very important point I should know, and I know this because I have private conversations with them, but I have a lot of contact in Europe with German economists, and they're good friends of mine and they usually say, "Eric, whenever you start talking we kind of agree with the first 30%, and then we get a bit confused in the middle, and by the time you've finished we're like, "No way." And they said-

Greene: I feel the same way, Eric, for what it's worth.

Lonergan: Megan knows where they're coming from, right? On this occasion, I had two German economists that said, "We listened to everything you said and we were kind of still nodding in agreement." Well, because it doesn't affect savers, right? Megan and I are actually recommending that you boost savers' depositors income. So what's really intriguing to me here is that the political economy of it is actually very different.

Greene: I would highlight, though, I mean, Eric, you mention that it's a little bit opaque and nobody quite understands it, that's kind of convenient as well though, because if you look under the hood a little bit, this is a subsidy to banks, and banks were widely viewed to have caused the whole last crisis and mess, and so if Joe Six-Pack got a whiff that we were providing a subsidy to banks, even if it was being passed on to the end user in loans because it's targeted, that would be pretty unpopular. So I also think it's a shame that nobody seems to have realized this is going on, but it's also somewhat convenient politically, it allows central banks to go ahead and do this.

Beckworth: Yeah. Well, you guys are the champions of it, right? You're the two fighting the good fight and promoting this, and I honestly wouldn't have thought of this had I not spoken to the two of you. Although I will mention one previous guest on the show came on, and we talked, and after the show is recorded we started doing some more discussion and he actually came up with the same idea. He didn't realize it was being implemented in Europe, but he said, "Look, David, why don't we just lower the discount rate below the reserve rate, that way you don't deal with all these concerns from savers and pensioners?"

Beckworth: And he kind of saw the logic, he kind of stumbled on it, I was like, "Let me tell you about two people I know, Megan and Eric, they've been making the case for this for some time. In fact, they call it rocket money fuel, I mean, they say it's really a powerful tool." I guess, Megan, part of it then is just how you sell it and market it, right? You want to do it in a delicate but informative way, and correct me if I'm wrong, I mean, you guys are saying, "Look, this is something you use in emergencies," right? This is something you use in a deep recession, this is not something you would use all the time, or am I wrong on that?

Lonergan: I have mixed views on that because I think there is a much more profound debate happening about monetary policy. And I think, and if anything that, in the pandemic, that's become even clearer, which is, a single interest rate is a very, very blunt tool, and it creates all of the problems that we're aware of, which is both primarily asset price distortions, or at least runs the material risk of those, and there is a huge concern in Europe about housing markets again. I mean, if you look in Scandinavia where they have negative interest rates, they have very, very, very elevated multiples of household income on the housing market, which is certainly a major concern of financial stability.

A single interest rate is a very, very blunt tool, and it creates all of the problems that we're aware of, which is both primarily asset price distortions.

Lonergan: So I think there has been a reassessment about is it really optimal for monetary policy to have a single interest rate as the dominant lever with which you're trying to control macroeconomic demand, and could you be more astute about how you target the stimulus? And I think that's a very legitimate question. It obviously poses problems, as Megan alluded to. So how does the ECB direct lending into the sustainable energy sector, and is it its role?

Lonergan: Now, I think you can set up smart institutional arrangements whereby you can do that. Whether it's analogous to the Fed going to the Treasury and saying, "Our balance sheet's at risk, do you give us approval to do this?" Whether it's like the Bank of England did something similar, it did a funding for lending scheme into housing during the financial crisis. And I think Europe has still got ... The important point as a macroeconomist about independent central banks, I want them to control quantity and price. That is sacrosanct. The central bank must be the authority on how much money is produced and that is enshrined in constitutional law in Europe, which exceeds the power of any individual sovereign. That is incredibly difficult to change. But it is actually also under the ECB's mandate, subject to price stability and independence, and not funding governments, it tries to operate in a way that's consistent with Euro area macro policy.

Lonergan: So I think there is a potential for some inter-institutional cooperation in how you might direct these kind of, the funding stimulus.

Greene: Yeah, I would say if you asked me to come up with a perfect system, would I lead with dual interest rates? I probably wouldn't, actually, I would probably leave more in the hand of fiscal authorities who are elected specifically to make decisions about asset allocation. So I wouldn't say that this is the first best solution, I just think it's the first best solution on the planet we actually live on, where you're already seeing political pushback on additional fiscal measures. I mean, the US is the posterchild for this right now, but the UK's facing it as well. So I would say, it's not necessarily just in an emergency, but I do think if you're facing a deflationary threat, that's the time to bring it out, and it's not the best solution, but it's the best one given the world we live in.

Beckworth: Yeah, and I encourage our listeners out there who do modeling, who write serious papers about these issues, to take up Eric's challenge to come up with an r* for TLTROs, an r* for discount rates, multiple r*s, I guess in a dual interest rate system. So maybe we need to come up with a Greene-Lonergan Taylor Rule of some kind, how do you set each of the rates conditioned on some state of the economy? So I mean, part of what you've got to do is market it, right? So John Taylor did a great job marketing the Taylor Rule and the whole interest rate control idea. I mean, it was already in the literature, but you need your rule to come out and show us how it works.

Beckworth: But this is a lot of fun, and I do really encourage our listeners to read your paper. We'll provide a link to it on the webpage. I want to move slowly from that topic into another one which we touched on earlier, and that is this fine line between monetary policy and fiscal policy. We've really been going back on it through a number of our comments, but Megan, you said earlier, "What's the big deal?" Don't act like this is some true law of nature, it's a bit of a fiction, is that right? That this like we've drawn between central banking and fiscal policy?

On the Fiscal vs. Monetary Distinction

Greene: Yeah, I think that's right. And again, maybe in a perfect world, you might try to delineate them very specifically, but in reality central banks are constantly figuring out who they're going to benefit and who they're not. So in some ways they're already political actors, every decision they make is political in some way. And so they haven't been elected to make those decisions, that's fair. But I think fiscal and monetary policy has already become so incredibly blurred, and even more so in the past six months, that I don't think that should be our primary concern.

Lonergan: I'm probably a bit more pedantic than Megan. Megan is absolutely right to me in the sense that when people talk about fiscal, what they often mean is distribution, right, is better distributional consequences. And I think the reality is, really until the financial crisis, a huge amount of thought wasn't given to the distributional consequences of monetary policy, and then you have the whole issue of whether QE was contributing to inequality, and then in the European context, because they're kind of geographically distributed, they're even distributed in different countries, you have cognizance that monetary policy can put savers and borrowers in conflict.

Lonergan: But here's the thing, I think there's a really interesting area, a kind of methodological point about economics, the more I've looked at this area, is that we actually, a lot of the key terms in economics are unscientific, in the sense that they're not properly defined. In other words, we just don't define what the kind of necessary and sufficient conditions are for what constitutes fiscal and what constitutes monetary, and this is actually true of an awful lot of terms in economics. It's very interesting, they're poorly specified.

Lonergan: And we kind of leave it to intuition. I mean, I actually described a lot of what the ECB was doing to Ben Bernanke and he said, "Oh, but that's fiscal." And I said, "Ben, you have to be a bit careful, because you call it fiscal, you realize that if it's fiscal, that makes it illegal in Europe." But then I took each of his point, I said, "Why is it fiscal?" And it was really interesting, because every point he raised, I said, "But that's true when you change an IOR or when you do this with interest rates or when you do QE." And so what you actually realize, if we're honest, is none of us have given a lot of thought to what the definitions of fiscal and monetary are, and I personally think you can define them relatively clearly, particularly monetary policy, because monetary policy to me is about the creation of base money and the price of base money. So that's a theoretical definition, so that's one type of definition. You can have a legal definition and you can have an institutional definition, so you can look at precedent and just say, "Well, what did the monetary authority do in the past? Let's call that monetary. What did the fiscal authority do in the past? Let's call that fiscal."

Lonergan: Or you can go to the lawyers, and you can argue in court over what's monetary and fiscal. I have to say, on those criteria, I think this policy is much more clearly monetary, and more so than many other policies. I mean, I think QE is definitely borderline breaching the law in Europe, which is why the German constitutional court is all over it, because there are points in time where, in effect, you could be eligible for QE, but you've lost market access, and that seems to me effectively to mean the central bank's financing you, which is illegal. I think it's debatable, the institutional point you can ... So I think this is much more about the fact that economics actually is very poorly specified in terms of a lot of the key terms that we use, which is part of the reason why these problems arise.

Beckworth: Okay. So let me concede points to both of you there. We haven't defined our terms very well, Eric. Megan, maybe this is a fiction, but maybe it's a useful fiction. So let me put it this way, maybe it's been productive to create this separation so that we can have price stability. The whole famous Fed accord of 1951, for example, where the Fed eventually said, "No, we're not going to keep supporting the interest rate peg." Can we do that without this separation? Whether it's a fiction or not, can we do that? Can we have fiscal policy, for example, taking a more dominant role in macroeconomic stabilization and still preserve price stability, macroeconomic stability in the long run? Because I think the argument has been, once you do give more and more responsibilities to fiscal policy it becomes tempting and hard to control, so how would you respond to that?

Greene: So yes, we can definitely have fiscal policy play a bigger role in macroeconomic stabilization. I mean, economists have known that for a long time. It's just when politics comes into it that it's a problem. So that is the first best solution, I think, to a lot of this. But given that it's not really happening and hasn't been happening in the way it should since before the last crisis, then I think policymakers need to look for other tools.

Beckworth: Okay. Eric, did you want to add something?

Lonergan: Yeah, I totally agree with what Megan said on this. And I would reiterate, to be clear, that I'm all in favor of good fiscal policy, that's a sort of truism, and I'm not an either/or policy advisor in that sense. My view is you should do the best fiscal policy and you should do the best monetary policy, and I think we need both at the moment. To your point, though, David, I think this is incredibly important, and I think it's an area which actually, the MMT debate actually hangs on this distinction, to me. Which is, I think there's a very good reason why we have monetary and why we have fiscal policy, and the distinction hangs on the creation of base money. And the truth of the matter is, you do not have any market discipline in the creation of base money, right? So the institution that can create base money has no market discipline. It doesn't have to sell base money into the market.

Lonergan: The fiscal authority issuing bonds, or the bond financing part of the state faces a market constraint, right? That market can close, or the market sets the price. Now, the point is the constraint on the creation of reserves is inflation, and for exactly that reason, it's not a market constraint. And inflation doesn't have to be a constraint; we've had hyperinflation, right? So you can hyperinflate, and then you destroy your monetary system.

Lonergan: That is exactly why we've created independent central banks. I mean, people seem to forget this stuff, right? And that does not mean they're not democratic, of course they are, that just means they're a kind of higher order form of democratic institution, in the same way that the legal system's supposed to be independent. So they're constitutionally protected, and they're protected by a higher order form of legislation. But there is an extremely good reason why there's monetary policy and there's fiscal policy, and it actually hangs on, do we want to have a market feedback that says to politicians who take control of our treasuries, outside of emergencies, national emergencies, but in normal times, "Sorry, you're actually being irresponsible now, so yields are rising." And do we want to have a different set of constraints, which is namely an inflation target, on the central bank?

There is an extremely good reason why there's monetary policy and there's fiscal policy, and it actually hangs on, do we want to have a market feedback.

Lonergan: And that is very, very clearly set out institutional structure in Europe, and I think that's something that one has to be really, really careful about challenging.

Beckworth: Okay, well speaking of inflation, let me use that as a segue into something I've been thinking a lot about, I'm sure you have as well, and that is the Fed's new average inflation target. So I was thrilled to hear the announcement, people like us get excited about these technical changes. That's something I've been kind of championing in my own work for a long time is make up policy, and this is one manifestation of it. It didn't go as far as I would like it, but I see it as a step in the right direction, I take a glass is half full approach to it. But Megan, I want to start with you, what are your thoughts on average inflation targeting? Do you see it as being credible, as working, as maybe even getting better over time, what are your thoughts?

Prospects of Averaging Inflation Targeting

Greene: Yeah, so I think it faces a lot of challenges. We're all excited about it, but it won't change policy any time soon, right? Rates are going to be really low for the foreseeable future. But there is a credibility challenge, as you point out. Since the Fed adopted a 2% inflation target in 2012, average inflation has been just under 1.5%. So the idea that the Fed is going to overshoot in order to make up for undershooting for so long, it's a nice one, but it's not clear that the Fed can, short of implementing things like dual interest rates, in which case it absolutely can generate inflation. But short of doing something like that, it's not clear that inflation's going anywhere significantly above 2% for any period of time. So I think that's a challenge.

Since the Fed adopted a 2% inflation target in 2012, average inflation has been just under 1.5%. So the idea that the Fed is going to overshoot in order to make up for undershooting for so long, it's a nice one, but it's not clear that the Fed can, short of implementing things like dual interest rates.

Greene: I also think there's a communication challenge, so just an inflation target is complicated enough, I think Joe Six-Pack doesn't really have much sense of what that means. If you ask people what inflation is, generally they're nowhere close to what it actually is. Inflation's a really personal experience depending on what you buy, so that's fair enough, but that's already complicated enough. Now coming up with an average inflation target, I mean, just try to explain that. That's going to be really hard, and also average over what period? We don't know yet, and it seems like the Fed is committed to not working it out for a while, to give themselves quite a lot of flexibility, but is it over a business cycle? How do you explain what a business cycle is to people? I think there's just a massive communication challenge, off the back of a process that really championed communication with the man on the street, right? The whole Fed Listens initiative was to try to get input and try to communicate with regular people.

Greene: Ironically, off the back of this, they've changed their monetary policy strategy so that no one who attends Fed Listens events, other than us, would understand what the heck this actually means. So I think that's a challenge too, but the more crucial one I think is the credibility issue, and I'm just not convinced that we're going to get inflation significantly above 2% any time, for any extended period of time, to offset all the undershooting we've done.

Beckworth: Well, Megan, it's interesting you mention the listening tours. I was at one, at the board of governors, the Eccles Building, and one of the questions that came up was how do you sell that we want to raise the inflation rate temporarily to the public, to Joe Six-Pack? Or how do you say, "Hey, I'm from the Fed and I'm here to raise your inflation rate." How do you communicate that? And of course, that's one reason I'm a fan of nominal GDP targeting. You don't say that, you say, "I'm here to raise your income or sales," but yeah, I think that's a real issue. That's going to be hard to get that past Joe Six-Pack, but also politicians, right? How do you tell politicians, "We want to have higher inflation the next six months to a year?"

Beckworth: That just seems like a losing battle, so it'd be interesting to see how this unfolds. Eric, I want to switch to you on average inflation targeting. One of the things that Megan brought up is it's not well-defined. And to the extent it does work, let's say Jay Powell does get it together and does prove Megan and myself wrong, he does raise inflation, so it works out great. There's still an issue that this is not defined well, so if someone else comes along, they could do it differently, right? And it seems to me you need some clarity on those parameters on average inflation targeting for it to really work well, in addition to the credibility concern.

Lonergan: Well, I think that’s a great point and I agree with everything Megan has said. And you know, I want to be positive, so they're trying to do something helpful, and broadly it's a good idea. But there are some challenges, and one of the things that makes me nervous is that one thing I like about having, in a sense, a live target, which is actually calculated by another institution, which is the inflation rate, is that you can have some degree of confidence, if you are a member of the public, that the Fed can't game its objective. So it's all kind of hands up, now, we're all missing our inflation targets, and that's not really subject of dispute.

Lonergan: If you start calculating an average, and we know, the three of us know enough about economics and statistics that you can then start arguing, well, how do you calculate your average, as Megan alluded to, what time period do you use, to what formulas do you use, which inflation rate do you use, and you can get all sorts of possibilities, even though I have complete confidence in the technical side of the Fed's activities that they would never game it, you just become open to that kind of criticism, which is harder to do, currently.

Lonergan: So I think, yeah, there's some ... It's well-intentioned. I think broadly, having broader inflation targets or averages makes sense, but I totally agree with all of the points you guys have been making.

Beckworth: Okay, well with that, our time is up. Our guests today have been Megan Greene and Eric Lonergan. We encourage you to check out their article, it's titled “Dual Interest Rates Give Central Banks Limitless Firepower.” Thank you, Megan and Eric, for coming back on the show.

Picture by DeFodi Images via Getty Images

People: 
David Beckworth
Calendar Date: 
Oct 5, 2020
Podcast Series: 
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Libsyn Podcast ID: 
16269749
Subtitle: 
With dual interest rates, central banks have the firepower they need to effectively respond to macroeconomic crises.

How to Respond to Recessions

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. 

Photo credit: Alankitassigments/Wikimedia Commons

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David Beckworth
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Apr 15, 2019
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A Macro Musings Transcript