The imagination gap of central bankers

It is very hard to feel sorry for central bankers. Well-paid, hyper-educated, unelected technocrats with enormous power rarely inspire public sympathy.

Nominal interest rates are as close to zero as possible. Real interest rates, which take account of inflation, are negative. eurozone inflation, at minus 0.1 per cent, is once again below the worst-case scenario in the ECB’s most recent stress tests for Europe’s banks. A tiny economy like Ireland can sell a 100-year bond and pay just north of 2 per cent on it. For 100 years! Think about what that implies.

The developed world, and particularly Europe and the US, is in dire need of large-scale infrastructural investment, at the very time that real interest rates on long-term debt are nearly zero. Yet, maddeningly, at the very moment that building lots of stuff is the right thing to do, Europe’s policy-makers are doing the opposite.

Drive on a road in Germany, which invests far too little in its infrastructure, and you’ll get a sense of why infrastructural spending is vital.

With fiscal routes more or less closed, it’s been down to monetary policy to do the heavy lifting to aid eurozone growth in the last few years. It’s a pretty weird time to be a central banker. The normal rules of economics don’t really work where we find ourselves, after the global financial crisis of 2008. So what should central bankers do? Well, they are being creative. Central bankers don’t really do creativity. They like to give the impression they are so dry that if they were cut open, they would bleed dust.

In fact, the balance sheet expansions and other asset purchase schemes the ECB has rolled out since 2012 have been highly creative, and are now focused on incentivising banks to lend into the system, to change people’s expectations about inflation, and to promote economic growth.

For example, the ECB is legally barred from printing money to finance government budget deficits, but its Outright Monetary Transactions (OMT) programme is credited with helping to halt the sovereign debt crisis by using the ECB’s promise of unlimited purchasing power to buy unlimited quantities of government bonds on the secondary market if needed. Ireland and other peripheral economies benefited directly from initiatives such as OMT.

Remember that there is no ‘European’ market the ECB can affect, only the 18 individual markets of its member states. The policies the ECB had to build were very different to those employed in the US and Japan. The results have also been quite different.

Overall, the European economy is now on a gradual path to recovery, but this recovery could be knocked off course by Britain leaving the European Union, a sharper than expected downturn in China, slowing global growth, and the oil and refugee crises in the Middle East and southern Europe.

The possibility of the eurozone sliding back into a deflation is always there. Deflation sets in when falling prices – typically asset prices such as gold, houses, etc – prompt rational people to delay their purchases, because they naturally expect prices to fall even further. This chain of expectations leads to a vicious cycle of downward prices. Consumer spending and private investment collapse, companies fire workers, and so spending falls even further as people lose their jobs and incomes. A financial crisis rapidly becomes a real crisis. Central bankers fear deflation because, like inflation, once it sets in, it is difficult to reverse.

The ECB is straining its mandate to the point that, incredibly, some commentators are suggesting the next step is directly creating money and putting that money into people’s bank accounts. This “helicopter money” idea has been rubbished out of hand by leading ECB figures such as Peter Praet – but remember, so was buying bonds on the secondary market. The ECB has so much power to change expectations that for Praet to deny helicopter money less forcefully than he actually did would count as a signal.

Writing in the Journal of European Public Policy, Domenico Lombardi and Manuela Moschella track the features determining the ECB’s development of its bond-buying programmes. They found the ECB’s legal mandate was the largest issue the ECB considers in all of its programmes. That the ECB found a way “around” the strictest definitions of the laws enshrining its independence shows the level of creativity it is willing to deploy, once the situation gets bad enough.

A recent Deutsche Bank report argued that the ECB actually had the legal freedom to pursue a helicopter money strategy, because it is legally prohibited from directly financing governments, not households. And households would be the agents getting the monetary fist-bump from the ECB.

Already, German finance minister Wolfgang Schäuble has accused the ECB of helping to fuel extremism and is working to undermine its independence, saying that “ECB policy isn’t helping trust in European integration”, and accusing the ECB of causing “extraordinary problems”.

These comments can be seen in the context of a close election, so deflate them (no pun intended) accordingly, but it is clear that German policy-makers are not seeing eye to eye with the ECB at the moment.

I have real concerns about whether helicopter money would actually work to increase inflation with interest rates as low as they are across the eurozone and so much money sloshing around in the system. It matters greatly how the money actually gets helicoptered in.

Say it comes in the form of deposit money in the government’s own current accounts, which would then be transferred into private deposit accounts like yours and mine, either as a tax cut or through additional public expenditure. Either way, you’d have more money than you would have otherwise, so you’d have a monetary expansion of some kind.

First, would people actually go out and spend all of this free money that just appeared in their bank accounts to increase the nominal demand for goods and services and other stuff?

Probably not. Some would pay down debt, some would spend it all, some would keep it in their accounts, some would give it to their kids.

Secondly, wouldn’t some people still buy financial assets with this money? Thirdly, wouldn’t this increase lower the interest rate adjusted for inflation over time? That is, we’d end up with even more negative rates. This last one, which is improperly called the ‘Fisher’ effect, is probably the most important, and needs to be studied further.

I’d bet real money that somewhere in the bowels of the ECB, in a windowless room, with a computer running Windows 98 and no internet connection, a little grey man is sitting, working out what the size of the Fisher effect is for every country in the eurozone.

I imagine other economists working these numbers out too, and I’d bet heavily that economists at Germany’s central bank have already run them. The numbers might well show that Germany will be walloped by a negative rate move if the ECB starts up its helicopter. Which might well explain Herr Doktor Schäuble’s recent animus towards Mario Draghi.