United Kingdom Economy: New Ways to Fight the Next Recession

LONDON (Capital Markets in Africa) – The U.K. economy has been teetering on the edge of the Brexit precipice for several years now. Should it stumble over, the slump that follows could call for a major boost — that’s harder now than it was in 2009. Bloomberg Economics explores ways to extend the runway for monetary policy to land new forms of stimulus, without compromising the Bank of England’s independence.

• A deep downturn would likely demand more from the BOE than the tools it has used so far can deliver — innovative stimulus will be needed if the worst outcomes are to be avoided.
• A helicopter money drop — money printed by the central bank and handed to the adult population — is a viable way to support spending. Critics dismiss it as an illusory free lunch or fiscal policy in disguise. Both are true, but that’s no reason to rule it out.
• Monetary financing of fiscal deficits might make stimulus easier to deliver and needn’t undermine central bank independence. It’s not hard to imagine a framework that keeps the government honest. And getting inflation back to target faster would bolster the BOE’s credibility, not erode it.
• The mechanics of monetary financing and conventional QE are similar — we should perhaps be less troubled by how the money gets into the helicopter and more focused on how and where it is dropped.
• There are no fiscal measures designed specifically to provide stimulus — we think that should change. Depoliticizing emergency tools and crafting them carefully could hasten their delivery and maximize their impact.

The Problem
Sooner or later Britain will be in recession. That could be next year if a disorderly Brexit throws sand into the wheels of the U.K. economy. Or it could be later, if a crisis originates elsewhere in Europe, among global trading partners, or in the financial system. Whatever the cause, the BOE has very limited conventional policy space. Governor Mark Carney has expressed reluctance to cut rates into negative territory — and while borrowing costs can be kept low for longer, that may not be enough.

The go-to policy response is QE, which lowers interest rates at longer maturities and raises asset prices to stimulate demand. But there are growing concerns about its efficacy — yields are already very low, and the wow effect that was the source of some of the magic it worked on the economy has faded.

Of the weapons touted to fight the next recession, few have attracted as much attention as outright monetary financing of fiscal deficits. It’s not a new idea — it’s been floating around since Milton Friedman first conjured the image of helicopter money in 1969. Former Fed Chairman Ben Bernanke discussed it in 2003 and again in 2016. It is a divisive one. Some fear it will lead to unbridled public spending and Venezuela-style hyperinflation.

We think these disaster scenarios can be avoided, and helicopter money may be the most desirable on a limited menu of options available in the face of a severe downturn.

The Mechanics of Helicopter Money
As the financial system has evolved, economists have moved on from Friedman’s vision of cash drops. Two general proposals have emerged: The first involves the central bank creating fresh electronic money and directly crediting the Treasury’s current account; the second sees the central bank using newly-created money to buy up bonds issued to finance fiscal stimulus. In our view, there is little difference between them. Here’s why:

Proponents of direct credit argue that it will deliver more bang for the buck because the money need never be repaid and does not have to bear interest. But, in a financial system awash with liquidity, paying interest on reserves is the only way for the central bank to keep borrowing costs where it wants them.

If it pays interest on reserves with yet more freshly-printed money, the central bank’s balance sheet would be put on an explosive path and this would eventually undermine its ability to keep inflation in check. If it pays it by reducing remittances to the Treasury, then the reserves it has created will look a lot like government debt and pay a similar rate of interest.

Directly crediting the Treasury’s account with freshly-created money is therefore little different from the central bank creating reserves to buy up new debt — some form of government liability is created in both cases. Investors would realize this.

Some of the interest costs associated with the extra reserves may be offset by an increase in the amount of hard currency held by the public, which does not pay a return. But that is likely to be a small proportion of the total and it may shrink in the future if cash becomes less popular.

The bottom line is that helicopter money is not a free lunch, as Claudio Borio of the Bank for International Settlements put it. But it might still be the best value meal going when the next crisis hits. Both methods of explicit monetary financing limit the amount of bond issuance that must be swallowed up by markets and take pressure off government bond yields. The Treasury’s rollover risk is reduced as well.

Is it different from regular QE? The basic mechanics show that it isn’t, really, and neither is it in practice. The BOE’s first round of gilt purchases was similar to the increase in government borrowing during the financial crisis. What all this suggests is that exactly how the money gets into the helicopter is likely to be less important than how it is dropped. But, if there are benefits to explicit monetary financing of deficits they are likely to stem from policy coordination:

• When the BOE prints the money, it can be sure it will find itself in the hands of consumers — that’s not guaranteed with conventional asset purchases.
• By providing the finance, the central bank is explicitly reducing the risk of a surge in government borrowing costs or a sudden decline in demand for its debt.

Keeping the Government Honest
Some fear that monetary financing will be exploited without limit, with disastrous consequences for price stability. We think that can be avoided and the U.K. is a good place to give it a go. It has a credible independent central bank and an independent Office for Budget Responsibility that produces its budget projections. Moreover, the government has resisted the temptation to interfere with either.

No doubt there are plenty of permutations of a framework that could prevent runaway inflation — the important thing is to have something in place before a crisis hits. Here’s one example:

• As a trigger to start the process, the central bank informs the Treasury it expects to hit the zero-lower bound, with inflation settling below the 2% target.
• The central bank assesses the size and duration of fiscal stimulus that would be needed to return underlying inflation to target at a reasonable time horizon and offers to finance it.
• The Treasury decides whether to do it, ensuring democratic accountability. If it does, it issues perpetual debt paying interest at the Bank Rate and the BOE buys it as the stimulus is administered. When the agreed funds are spent, the central bank stops buying.
• The Treasury could do more if it wants to get things moving faster. But any additional spending would be debt financed and bring the central bank’s first interest rate hike nearer.
• If the Treasury wants to do something else entirely, it can. But it will be debt financed — there’s no monetary Carte Blanche to spend.

How to Spend It
During the financial crisis, the British government’s fiscal stimuluscomprised two main measures. The first was a cut in the rate of Value-Added Tax, which came into effect after only a few months — the evidence suggests it was effective in lifting spending. The other leg of the package was bringing forward about £10 billion of investment spending planned for later years. Overall, the discretionary stimulus package was actually quite small — about 1.4% of GDP.

Investment spending tops the list of fiscal multipliers the OBR uses in its economic forecasts — it packs a punch, but has limitations. The biggest is that there are simply not enough shovel-ready projects to deliver a big dose of stimulus quickly. And why should there be? If a good value scheme is ready to go, it should be done — there’s little point in living with a large stock of pot holes, just so they can be filled in when the economy tanks. Capital budgets are also the first to be squeezed when the economy is recovering because such cuts have few immediate victims — this leads to poor decisions when judged over longer time horizons.

The OBR’s Fiscal Multipliers
1 – Capital Spending
0.6 – Departmental Spending
0.35 – VAT Cuts
0.3 – Income Tax Cuts
0.3 – National Insurance Contribution Cuts

The other options bring their own challenges. Departmental spending is a poor stimulus tool. Spending envelopes are set over a five-year horizon, and with good reason — it enables departments to plan how best to spend it for the long term. Income tax cuts are complicated by the distributional consequences and have a very limited impact on spending by high earners. Cuts to national insurance contributions do not reach the self-employed or pensioners.

As the government VAT cuts show, it is possible to craft a fiscal policy and enact it quickly. And the table above underplays the impact of the policy because it relates to a permanent cut — a temporary reduction has a far bigger multiplier because it encourages spending to be brought forward from the future. The trouble with this measure is that it lowers inflation. For a central bank that may have to contend with deflation during a downturn, a big fall in headline inflation is unhelpful.

The broader problem is that all the options on the fiscal policy menu are intended to meet different objectives — to raise revenue efficiently, deliver public services or lift welfare. So why not come up with a new fiscal tool that is specifically designed to stimulate the economy?

A measure agreed in advance, that has cross-party support and the infrastructure ready to implement it, could deliver a big dose of stimulus almost overnight.

Perhaps simple could even be best. In that spirit, here’s an imagined statement from the Bank of England in 2025 as it embarks on its first helicopter money drop:

“Growth has slowed, unemployment is rising and interest rates can be cut no further. To help return inflation to target, the Monetary Policy Committee has agreed with the government that every U.K. adult is entitled to £750 to spend in the first half of this year.

To claim it, simply scan the QR code below to download the Spendit app. Once you have created an account and confirmed your identity with the government’s VERIFY scheme your account will be credited. Your balance will expire on July 31. To use it, simply open the app and tap your phone against a contactless terminal at any U.K. retailer or use your unique in-app code to shop online.”

Helicopter money may never take off. If it does, economists should have ideas for boosting its impact that are ready to fly.

Jamie Rush is Chief European Economist for Bloomberg Economics in London. He has previously worked at the British Treasury, the New Zealand Treasury and the U.K. Office for Budget Responsibility. He holds a PhD in economics and was formerly known as Jamie Murray.

Source: Bloomberg Business News