entral bankers like to conduct monetary policy by counter-cyclically altering a short-term policy rate. They also like to do so via guidance from some variant of a Taylor Rule, which posits how much the policy rate should change given where inflation and unemployment stand relative to explicit or implicit targets.

Central bankers also like to conduct open market operations primarily in government securities, rather than securities – public or private – that channel credit to particular sectors. And, finally, they like to run their operations with minimum excess reserves in the banking system, meaning that they are only monetizing government debt to the extent necessary to fulfill the public’s demand for currency and banks’ required reserves, so as to avoid charges that they are the handmaiden of profligate fiscal authorities.

Yes, this is the world of conventional monetary policy, undergirded by the doctrine of central bank independence, founded on the proposition that fiscal authorities, hostage to the political process, inherently are prone to an inflationary bias.

When, however, the economy suffers from Post Bubble Disorder, characterized by private sector deleveraging and a fat-tail risk of deflation, conventional monetary policy doesn’t cut the mustard. In such a liquidity trap, private sector demand for credit is, axiomatically, very inelastic to low interest rates, as evidenced by contracting private sector debt footings, even when the central bank’s policy rate is pinned against zero.

In such circumstances, the central bank has a profound duty to act unconventionally, ballooning its balance sheet by monetizing assets, either government or private, or both. Put differently, the central bank has a profound duty to meld itself with the fiscal authority, until the fat-tail risk of deflation is cut off (and then killed, in the famous words of General Colin Powell).

Does this imply that the central bank should surrender its independence during the anti-deflation campaign? Legally, no. It will always be the case that the fiscal authorities have an inherent inflationary bias. Thus, the doctrine of central bank independence is of enduring value to cut off the fat-tail risk of inflation. But when that tail is not fat, but too skinny, while the deflation tail is both fat and incipient, the meaning of central bank independence fundamentally changes.

Remembering the Chairman’s Words

“The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say ‘no’ to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty.”³

Yes, those are Mr. Bernanke’s words. And as an example of a “more cooperative stance on the part of the central bank,” Mr. Bernanke suggested “a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt – so that the tax cut is in effect financed by money creation.”

Fast forwarding to today in the United States, it is true that we are not experiencing goods and services deflation, as was the case in Japan in 2003 (and now). Yet inflation in the United States is presently well below the Fed’s implicit target, in the context of a huge unemployment gap, implying that inflation will likely fall further.

And as a practical matter, there is nothing magic about the zero line for inflation. Inflation that is too low implies similar pathologies as actual deflation, just not as severe: Incentivizing private sector deleveraging, even while making it more difficult to achieve, generating negative animal spirits and a chronic shortage of aggregate demand relative to aggregate supply potential. Or, cutting to the chase, exactly what is unfolding in the United States right now.

In such circumstances, fiscal policy restraint is not a virtue but a deflationary vice. What is actually needed is yet greater leveraging of the fiscal and monetary authorities’ balance sheets. Indeed, what is needed is for them to view their balance sheets in a consolidated way, and for the authorities to explicitly make this clear to the public and act accordingly.

Indeed, this very idea is what gave Chairman Bernanke his nickname of Helicopter Ben back in November 2002, when discussing possible remedies to deflation in the United States were it to unfold. Here’s what he said:

“A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman’s famous ‘helicopter drop’ of money.” ⁴

To be sure, Mr. Bernanke did not advocate such a course as a prophylactic against deflation, but rather deflation itself, which he saw as a remote risk back in 2002–2003. And it proved to be, primarily because the Fed’s conventional easing, taking the Fed funds rate to 1% and promising to hold it there for a “considerable period,” proved adequate to induce increased private sector leverage, notably in the property markets, fueling rising prices and wealth creation, which the innovative financial industry was willing to monetize for the public via levered equity extraction. Put simply, conventional monetary policy (coupled with the innovation of the “considerable period” pre-commitment) was effective then because the U.S. economy was not in a liquidity trap.

But the housing boom, riding not just easy money but a systemic degradation of underwriting standards (per Minsky⁵), morphed into a bubble that burst, and the household sector is presently not only unwilling to increase leverage but is deleveraging. That is called a liquidity trap. And, unfortunately, that is where we are in the United States. Thus, I believe the argument for the Fed to explicitly commit to print money to fund increased fiscal expansion is growing by the day.

But unfortunately again, the argument for such a course is growing much more rapidly than the odds of such a course. Why? First and foremost, for the monetary authority to monetize a fiscal expansion requires that the fiscal authority actually desire to pursue such an expansion. That should be easy. But surreally, Congress is presently wrapped around the austerity axle. I happen to think this is bad policy, very bad policy, but what I think matters for naught. Congress isn’t willing, and the Administration, which I think would be more amenable, doesn’t have the political capital to change Congress’ collective mind.

But that could change, if the risk of a return to recession continues to rise, spooking the equity market. A few thousand points of Dow might be what is needed to get the attention of Austerian legislators wanting to get re-elected! Am I forecasting that? Not yet, but the odds are rising, I think.

And part of the reason is the equity market’s reaction to the Fed’s decision this week to hold constant its balance sheet, rather than let it passively shrink with the roll off of its agency MBS and debenture holdings. I hasten to add that I applaud the Fed’s decision to redeploy the roll off into longer term Treasuries. It was very much the right thing to do. But the equity market’s reaction is strong evidence of the growing ineffectiveness of unconventional monetary policy alone when in a liquidity trap.

Bottom Line

To generate increased growth in aggregate demand, some sector of the economy must be willing to pro-actively lever its balance sheet. And that must be the fiscal authority, if the private sector is intent on delevering. Yes, I know all about the perils of long-term fiscal unsustainability. But I also know that in the long run, we are all dead. I see no reason to die young from fiscal-orthodoxy-imposed anorexia.

While the Fed has not sounded the horn on QE2 (Quantitative Easing), it has declared that the band will keep playing at the same volume on QE1. That decision was and is important, I think, not for any meaningful direct stimulative effect on the economy, but rather because it signals that the Fed is no longer on an exit strategy from QE1 – the unconventional, presumed to be temporary, has morphed into the conventional.

This is a profound change, because it means the intellectual and institutional hurdle for QE2 has been dramatically lowered. The textbook monetarists wrapped around the inflation axle of a bloated monetary base have been defeated: Money is as money does and the bloated monetary base ain’t doing anything, because the economy is in a liquidity trap of private sector delevering.

It is especially sweet that St. Louis Fed President James Bullard led the public charge for keeping the band playing at the same volume on QE1. When the head of the regional Fed bank with the greatest tradition of textbook monetarism helps re-write the textbook to reflect liquidity trap realities, it’s a good day, a very good day, in the macroeconomics neighborhood.

So, do I think QE2 will be pulling into the harbor quickly? The honest answer is that I do not know. I actually hope not, because I believe that QE2, if she is going to sail, should sail with a meaningful fiscal expansion on board, on the back of Chairman Bernanke’s cogent analysis back in 2002–2003. The Fed can’t turn deflationary milk into a reflationary milkshake by itself. It needs the fiscal authority to show up with a proactive blender, sweetened with bigger-deficit sugar.

This should not be hard. Indeed, the irony of ironies is that the fiscal authority, from time immemorial, has craved a monetary authority that would be openly cooperative. And to Congress’ credit, recognizing the inflationary potential of such a craving, it wisely extended independence to the monetary authority. But, right now, Congress has a once-in-a-lifetime (we hope!) opportunity to exploit that craving. But it isn’t seizing the moment.

This is not only irony; it is sad. The nation deserves better, especially the 8 ½ million Americans who have lost their jobs. When deflation is the fat tail risk, when the Fed is willing to monetize deficits, there is no excuse for the fiscal authority to resist running bigger deficits to directly finance job creation.

No excuse, none at all.

Paul McCulley
Managing Director
August 13, 2010
mcculley@pimco.com

¹ Some Unpleasant Keynesian-Minsky Logic,” Global Central Bank Focus, June 2010

² What If,” Global Central Bank Focus, July 2009

³ Some Thoughts on Monetary Policy in Japan,” May 2003

⁴ Deflation: Making Sure ‘It’ Doesn’t Happen Here,” November 2002 

⁵ The Plankton Theory Meets Minsky,” Global Central Bank Focus, March 2007