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Direct Transfers as Monetary Policy

September 6, 2013

A “monetary transmission mechanism” is a fancy way of saying how does a central bank achieve inflation? Central banking is currently conducted by buying government bonds from a small number of large banks at or around market prices using newly created money, which the banks use as reserves. But that’s not the only way newly printed money could enter the economy.

What are good goals for a transmission mechanism?
In the long run, any mechanism will be neutral, as the money eventually spreads out over the economy and prices adjust. However, in the short run, various mechanisms will vary widely in terms of their impacts on relative prices (Cantillon effects). For example, if the Fed conducted monetary policy by buying apples with the new currency, the price of apples would increase during expansionary policy and decrease during contractionary policy. The good which the Fed buys should therefore be sold in a highly liquid and deep market. Treasury bonds are thus a good candidate, since around $70 billion dollars of Treasuries are bought and sold every day.

A blessing and a curse of buying financial assets is their “distance” from consumer spending. Depending on whether you believe in long and/or variable lags, this can be a problem. Market monetarists have argued that expansionary policy results in immediately higher spending and inflation expectations, even if the banking sector is in the midst of a crisis. It’s hard to determine whether they are correct, since in the current recession, the Fed has been ambiguous with their intentions and interest on reserves have limited the impact on standard open market operations. As a believer in the efficient market hypothesis, I think inflation expectations should reflect all publicly known information about the Fed’s intentions. However, there are many political as well as economic forces influencing Fed behavior. Bernanke can’t just pick an inflation rate, but instead has to pay lip service to financial sector stability. Those political forces not only add ambiguity about what the Fed will do in the future, they also disallow the Fed from communicating their intentions, even if those intentions were stable.

Even if the Fed wanted 2% inflation, they couldn’t just say “We’re going to have 2% inflation”, they’d have to hem and haw about how much profit Goldman Sachs will get and what oil prices will be, and what the yen will do in a month, and all sorts of other unrelated things. The interest rate method of communicating monetary policy doesn’t help either.

On the other hand, paying people a “stability stipend” is a pretty clear signal. Cutting every American a check for $500 is a clear signal that you want them to spend more and is easily understood by even the stupidest Congressperson. The seigniorage would be evenly spread across the population, and would help people repair their own balance sheets quickly, limiting the impact of a Minksy moment. Once balance sheets were repaired, people could invest again, stabilizing capital markets.

Pros and Cons
I believe that the entanglement between the banking sector and the Fed is harmful. The Fed spends far too much time worrying about the profit levels of a select group of firms, simply because those firms are the way the Fed gets money into the economy. If banks sit on the money, as they have done in the last recession, the Fed loses a lot of response power. A direct transfer removes the banks from the equation, even if temporarily. Banks too afraid to lend? Who cares? Just give it to “mainstreet”, and I guaranty that someone will spend it. A wide distribution in the income will result in a more equitable distribution of seigniorage than the status quo.

One disadvantage is that it could become politicized and people could pressure Congress to either keep it stable in the boom, or increase it endlessly resulting in runaway inflation. If either happened, that would be significantly worse than the status quo. Stable payments would defeat the entire purpose of economic stabilization and hyperinflation is pretty much the worst thing that can happen to a currency. Perhaps a lump sum transfer should be reserved for only the greatest recessions, such as a drop of 5% or more from NGDP. In such circumstances, people would probably understand the temporary and extraordinary nature of such a transfer payment. In that way, it would be used instead of how fiscal stimulus is used now: only when things get really bad.

Further reading:
Foolproof approach to monetary policy.
Just give people money

This is my 400th post!

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