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In the Latin translation of the bible, when God first made something out of nothing he said, “fiat lux” — “Let there be light”. When governments and central banks create fiat money, they are much less powerful. God is omnipotent, but monetary authorities cannot stop money from multiplying and disappearing.
But they can still create it and, potentially, destroy it. Adair Turner, the executive chairman of the UK’s Financial Services Authority, broke a taboo last week by suggesting that governments should sometimes do just that, notably by printing money to cover deficits in difficult times. It’s a better idea — with a stronger pedigree — than today’s conventional economics allows.
The supply of economically active fiat money increases when banks lend out deposits and when people decide to hold less on deposit as a safety cushion. Wages and prices rise unduly when the supply of money rises faster than the supply of purchased labour, goods and services. When the monetary excess goes into financial markets, asset prices rise sharply.
Conversely, prices fall whenever banks, employers, consumers and investors beat a hasty retreat. Modern macroeconomics was born during one such rout, the Great Depression of the 1930s. The founding principle was that government should spend when people and companies wouldn’t. Economists subsequently developed tools for monetary management, including fiscal deficits and surpluses, central bank policy interest rates and various sorts of systemic regulation.
In both the early 1960s and the early 2000s, leading economists thought that these tools could make governments God-like in monetary matters. But “fine-tuning” ended in high inflation and the Great Moderation collapsed into the 2008 crisis, a deep recession and a slow recovery. Still, most economists have not lost faith. They think that the current toolkit needs only a few tweaks. But Turner suggested deploying a much more powerful piece of equipment, which he called “overt monetary finance”. Instead of borrowing funds to pay for programmes when tax receipts fall short, government could simply print the needed money.
His mention of OMF broke with recent convention. Almost all economists think that OMF is an invitation to governments to spend and print their way to inflationary ruin. Even Turner was circumspect, firmly stating that the technique should be reserved for extraordinary times.
Turner could have been bolder. OMF and its correlative — call it “overt monetary destruction” or OMD — are superior to the current techniques of monetary management. That was what the economist Milton Friedman thought in 1948. Turner goes so far as to say that John Maynard Keynes agreed, a rare convergence between economists who have become figureheads for the political right and left, respectively.
The problem with the prevailing toolbox is that it contains only indirect means for central banks to try to control the monetary system. Policy interest rates are supposed to nudge banks and investors to lend and spend more or less, but the response is not always as desired. The latest campaigns of bond buying or quantitative easing — a technique, as Turner points out, that is close to OMF — have been weakened because little of the additional liquidity created by central banks has moved into the active economy.
Fiscal deficits do put additional money directly into the bank accounts of potential spenders. But if that is the desired goal, then borrowing to fund the same deficits is counterproductive, as it takes money out of the same banks. Also, when national levels of debt are already undesirably high, as now, adding to them only worsens the problem.
OMF would work more directly, putting the fiat back into money, as it were. Creating it could take Turner’s recommended form of unfunded fiscal deficits. But central-bank “helicopter drops” of money would also work. Ben Bernanke suggested as much before he become chairman of the US Federal Reserve. Monetary destruction would be rare in an expanding economy, but it is possible through fiscal surpluses or draining cash out of the banking system.
Taking this direct approach would leave markets free to set interest rates, and market forces would also have more influence than they do now on financial asset prices. Consumers would have more reason to expect steady retail prices and less to entertain dangerous hopes of asset price bubbles.
The big caveat is that governments would have to use OMF responsibly, because the restraints provided by sovereign debt markets and independent central banks would not apply. Turner hints at boards of impartial wise men with the legal power to block excesses that might bring runaway inflation and other ills. No such body can be foolproof. But the existing arrangements, which failed to rein in a gigantic credit bubble, hardly inspire confidence for the next time.
Once the principle of OMF was accepted, the debate would shift to current policy. With leverage levels uncomfortably high, OMF might be used to give people and companies enough money to pay down their debts and also to pay huge tax bills, which would in turn allow governments to cut their borrowings. A subsequent bout of OMD might then be needed to mop up any excess money. It would require discipline and some luck to get the balance right. But if Friedman and Keynes both thought it a better method, it could be worth a try.