Forget quantitative easing, why not try the Billion Pound Drop!

nick cowen, 26 August 2011

As the world economy teeters on the edge of another recession, Keynesian-inclined economists are coming up with more and more outlandish ideas for stimulating the economy, from encouraging shoplifting, to faking an alien invasion as an excuse to ramp up military spending. These mechanisms, I will try to argue, while insane, do indicate how current approaches to economic stimulus might be improved.

The idea that destructive events can boost economic growth has been considered a fallacy as far back as Frederic Bastiat’s famous broken window story. The fallacious reasoning has it that when a baker’s window gets broken, the baker is forced to pay to have it replaced by a glazier. Then the glazier can spend the money he receives on something else and the economy is ‘stimulated’. Bastiat pointed out that if the baker isn’t forced to replace the window, he could have spent the money on something else instead; perhaps a new suit. The seen and the unseen aspects of the economy balance out and so all you are left with when you break a window is… a broken window rather than a nice and complete window.

Some economic theorists now dispute this. They say this fable only applies in a situation of full employment. If resources, such as those of the glazier, stand idle, as in a depressed economy, then that is just another form of wealth destruction. Breaking a window or two in this context would boost demand and, therefore, employment. It would force the bakers of this world to dig into their pockets and spend money on maintaining their property and business. One sometimes cited example of this is Word War 2. This is widely held to have ended the Great Depression in the US through a forced increase in government expenditure and employment (as soldiers and labourers for the military campaign). If only the catastrophe were big enough, so the argument goes, then we could force any society out of a downturn.

But how is it that destruction of property could boost an economy? Obviously, it is not the destruction itself. War and other disasters might allow some important public works to be completed. It might even contribute to the sense of social cohesion that aids the sense of trust necessary to engage in co-operative economic transactions (it could do the opposite too). But perhaps the most important thing that responses to these disasters do is put money in people’s pockets. Whether they are public sector workers paid to fight or prepare for war, or private tradesmen replacing broken furnishings, money is circulated by being taken from private savers or having been borrowed by government.

This is the main lesson to be acknowledged from Keynesian economics and has since become a mainstream idea: whatever else is going, recessions are caused by an excess demand for money compared with the goods and services available. People and companies do their best to hold onto cash and spend less. This is what leads to net job losses. Even Milton Friedman, one of the greatest opponents of increasing Government spending, went so far as to claim that a central bank should go so far as to arrange ‘helicopter drops’ of money on a population if deflation (caused by excessive demand for money) was at risk of taking place. In fact, one key difference between monetary stimulus (favoured by monetarists in a recession) and fiscal stimulus (favoured by many Keynesians) is that fiscal stimulus involves the government paying people to do things.

In practice, however, monetary stimulus hasn’t taken the form of anything like a helicopter drop. In the current crisis, monetary policy has involved lowering interest rates to banks and, when interests rates can’t get much lower, engaging in quantitative easing. This involves the central bank (the Bank of England in the UK, the Federal Reserve in the US) crediting itself with new money and then using it to buy up the assets of major banks. By monetising bank assets, the theory is that you end the excessive demand for money and encourage banks to lend more to business.

Unfortunately, the result of this sort of stimulus has been rather disappointing. Lending to businesses remains low, employment mediocre and we are still getting inflation. In fact, the benefits of the stimulus seem to be rather concentrated on bank balance sheets, bankers’ bonuses, share prices (at least temporarily), and the house prices in parts of London where bank employees tend to live. Monetary stimulus, as much as it may be necessary, also seems to constitute an implicit bail-out of the banks. The fact that the City of London is the key beneficiary also suggests that this policy has profoundly regressive redistributive effects. Everyone else gets inflation, whereas bankers and those around them get inflated salaries and assets.

This makes one wonder if there would be a way of injecting more money into the economy which doesn’t involve either enriching bankers or starting another world war (whether against Krugman’s aliens or not). Perhaps the model of premium bonds (run by National Savings and Investments) offers an answer. Suppose that individuals were encouraged to purchase, cheaply, during times of stability, monetary stimulus lottery bonds. Then, when a monetary stimulus were judged by the BoE to be necessary in a moment of crisis, the newly credited funds at the BoE could be split into small cash awards (like £200) and distributed evenly (or randomly, depending on the size of the stimulus) to bond holders.

Some winners would go out and spend the money, stimulating current businesses and saving jobs. Others would add it to their savings and so long as their savings are in bank accounts, the demand for money holdings will go down, encouraging banks to lend. If nothing else, it would at least help offset the contraction of money caused by banks deleveraging during a credit crunch, but it would do so by benefitting ordinary depositors. The scheme would still benefit banks, but they wouldn’t be the ones receiving the essentially ‘free money’, as they do currently, through extra-ordinarily low interest rates, or assets bought for more than they might be worth.

The buy-in could be restricted to, for example, £50, for each individual in order to prevent rich individuals from grabbing the lion’s share of the winnings. The bonds could even be given out to every British citizen when they receive a national insurance number. But crucially, this mechanism of increasing the money supply would be broader than a top-down distribution that currently seems to concentrate benefits almost exclusively in the banking sector.

There are disadvantages to this proposal. Current monetary stimuli are designed to be reversible as soon as the economy recovers (the BoE can sell assets back to banks in order to reduce the money supply, preventing inflation). You couldn’t recall these prizes. Worst of all might be the psychological or even moral effects of involving everyone in a free money draw, undermining the sense that money has to be worked for. Perhaps this is exactly what has caused bankers to end up behaving so badly. I am not sure whether it is worse to concentrate such an attitude amongst the economic elite of our society, or disperse it evenly throughout.

As a result, added to the mix of monetary policies, and having already accepted the need for some measure of inflation, this scheme could ensure that we have a slightly more progressive (or at least less distortionary) method of avoiding deep recessions.