Tuesday, 29 October 2013

Two Unconventional Ways To Boost The Economy

by Harry Dry


Helicopter drop (see below)
 
Earlier this year Mark Carney, governor of the Bank of England, unveiled a new “forward guidance policy.” He announced that interest rates would remain at their present, extremely low,, rate until unemployment falls below 7%. This makes good sense as employment falling below 7% would indicate that the economy is well and truly on the mend; Carney could then raise interest rates, increasing the cost of borrowing, reducing the inflationary possibilities that would damage the economy. By offering guidance to firms and the population about the date when interest rates rise he allows the opportunity for them to look ahead and plan accordingly for the future, as they are more aware of the future costs which they will incur.  Although Carney’s policy is all well and good, I question whether it will have the impact on the economy which other, riskier polices could.
Negative Interest Rates
Potentially the most extreme sort of monetary policy, it is considered as the ultimate market distortion. Negative interest rates mean that if you store some money in a bank, or building society every year a % of this money is taken by the bank. And, if you take out a bank loan, every year the bank pays you a % of the amount of money which you take out. Although seeming a ridiculous policy, its purpose is simply to get an economy moving again. When spending in an economy by both firms and consumers is low, it could be because the cost of borrowing the money (the interest rate) is too high. However, there comes a point when even the base rate of interest can’t stimulate any more spending. This signals a liquidity trap, where there is very little cost to holding more cash due to the extremely low interest rates, yet still demand is low as near zero interest rates can’t provide a large enough incentive to spend. There is no incentive to spend because, when recovering from a recession, all individuals have had their finances hit. Hence, they are determined to reduce their personal deficit or increase their surplus. As a collective group this is unachievable, and so leads to a depressed economy with demand near static levels.
One way to guarantee spending in an economy is implementing negative interest rates. There is now a reward for taking out loans and so spending and there is now a cost to saving. This has the effect of changing people’s incentives dramatically and, although it carries serious complications, it can ensure that demand in an economy will pick up. A small increase in demand will soon multiply throughout the economy, increasing employment, future investment and aiding the government in reducing the national debt via increased taxation. 

Helicopter Drop
An idea of the famous monetarist Milton Friedman, who believed strongly that there is a strong link between the amount of money circulating in an economy and the price level. He famously quipped that in order to stop deflation and increase the rate of inflation money could ‘simply’ be dropped out of the sky. This term "helicopter drop" is more loosely used nowadays as a policy with several similarities to quantitative easing. Although implementing a policy like that now would be a bad idea with inflation already above target level, an increase in inflation would enable massive public and private debts to be brought down. As inflation decreases the value of money, so it decreases the size of people’s debts. Interestingly, World War II government debts were reduced dramatically by severe inflation post war.
Having said this, it is excessive risks by banks which caused the recession in the first place and, by playing it safe for the moment, steady growth can occur and consumer confidence should gradually pick back up.

4 comments:

  1. The first one is effectively what the Government is currently doing (near 0 interest rates), and it isn't working. The reason they haven't set negative interest rates is because people still wouldn't spend because of confidence issues, and banks would lose money on loans, and seeing as that's one big revenue stream for banks, they'd probably go bust again. Then the Government will have to bail them out, resulting in increased Government debt, Osborne would cut spending again, confidence will go down, and the economy will be a mess.
    The second just screams hyper inflation.

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  2. Regards the second policy, in normal circumstances I would agree, hyperinflation would be a danger. However, In liquidity trap, surely this isn't a problem? For Example, in the US the monetary base has risen by 300 percent, but prices have only increased by 25% since 2007. In fact the more likely problem that the were would be too little effect on inflation and output, not too much.

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  3. Regards to the negative interest rates. Although the interest rate would be negative, the real interest rate wouldn't be negative. Hence people wouldn't take out loans just to wait for the purchasing power of their loans to decrease because inflation exceeds the rate at which the bank is paying them back at. The only people taking out loans at negative interest rates would be forced to spend and invest and also i'm sure that banks wouldn't offer loans if there was no investment or spending guaranteed. The whole point of this policy is that an interest rate of 0.5% isn't enough to encourage spending at this point. Just the huge unprecedented statement of a negative interest rate would definitely improve spending. Finally the negative interest rates wouldn't be introduced across all financial markets and only on certain much more predictable ones. The Swiss national bank temporally set negative interest rates on the fixed foreign currency market last year and there was no issues. The policy does undermine the banks, however there are markets where they would still be willing to comply and I'm sure negotiations could be made.

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  4. Interesting ideas - When you find out where the helicopter drop is going to take place can you let me know, and I'll turn up with some big buckets....on a more serious side, any quantitative easing is bound to have unequal impacts on different sectors of society. The current QE is benefiting banks probably more than households. A helicopter drop would benefit the fit and fast, over the slow and small.

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