Part 1: Accommodating private sector savings and NGDP growth

Helicopter Money: Or How I Stopped Worrying and Love Fiscal-Monetary Cooperation

"During private deleveraging cycles monetary policy will largely be ineffective if it is aimed at stimulating private credit demand. What matters is not monetary stimulus per se, but whether monetary stimulus is paired with fiscal stimulus (otherwise known as helicopter money) and whether monetary policy is communicated in a way that helps the fiscal authority maintain stimulus for as long as private deleveraging continues. Fiscal dominance and central bank independence come in secular cycles and mirror secular private leveraging and deleveraging cycles, respectively. As long as there will be secular debt cycles, central bank independence will be a station, not a final destination."

Out of Many, One? Household Debt, Redistribution and Monetary Policy during the Economic Slump*

One could, indeed, go further and regard the financial position of firms and households more generally as a potential source of systemic concern. This would be in the tradition of the 'debtdeflation' literature of the 1930s. A number of writers have pointed to the possibility that an excessive build-up of corporate and household sector debt during a period of economic expansion carries the danger of exacerbating recessionary tendencies when the downswing in a cycle comes around. This is because a weakening of economic activity both increases the difficulties economic agents face in servicing their outstanding debt, and reduces their net worth, making it harder for them to engage in further borrowing. There can be little doubt that excessive debt levels have a potential role to play in transmitting the effects of financial instability to the real economy …”

It is the volume and speed of credit growth that is more telling of whether an economy is experiencing excessive financial exuberance or in the midst of deleveraging.  A rising neutral rate is a by-product of improving aggregate nominal income growth funded by an expansion of credit. On the other hand, a neutral rate that keeps falling is indicative of slowing GDP which carries the risk of financial instability as liabilities become more difficult to service.  It is when aggregate income fails to meet prior expectations due to an unforeseen adverse shock that debt loads become burdensome especially liabilities that are short-term and run prone in nature**(See bold below).  Once counterparties refuse to roll-over short-term debts, financial distress, fire sales, falling asset prices, and financial disintermediation all feedback into weakening nominal GDP.

Problematically, falling NGDP growth simultaneously reinforces negative future expectations, excessive risk aversion, and further financial distress.  Financial intermediaries are not only under strain because of deteriorating loan performance and falling asset prices, but as a result of their inability to issue short-term debt at a time of financial panic.  This manifests itself through private sector deleveraging (the rebuilding of net worth either by accumulating safe assets or reducing liabilities), the shedding of labor (rising unemployment) and the underutilization of capital.  This spare capacity along with declining demand due to rising unemployment and diminished corporate earnings puts downward pressure on the price level and market interest rates.

Moreover, as the private sector attempts to stockpile financial assets, some other agent in the economy must either draw down their savings or issue financial assets in order to facilitate this desired accumulation.  If this does not occur voluntarily, this desire to save will cause spending on goods and services to fall as short-term money like securities are hoarded.  The savings of one party is at the expense of the unemployed and firms who both suffer a fall in income/earnings.  Not only does this depress economic output, but the total savings of the private sector may not necessarily rise at all.

As the outlook for inflation and employment worsen, market participants begin to anticipate that the central bank will be forced to respond by expanding their balance sheet and cutting the policy rate until a semblance of stability is resorted.  The hope being that once this has occurred, the private sector will make use of the spare capacity, excess labor, and low rate environment to undertake a greater degree of investment spending.  As this happens, the output gap is closed as the economy produces to its full potential.

However, if monetary policy* fails to gains traction as the non-government sector is simply unwilling to issue debt and increase spending to soak up the idle labor and available resources (interest rate insensitive), then this will create fiscal space for the government to do so.  As witnessed in the post-GFC period, this condition will result in rising government bond prices which should serve as a signal that the non-government sector demands such securities.  Once expectations rebound as aggregate spending and output are restored to full potential, the economy's spare capacity will vanish and government bond yields will rise.  Thus, when the private sector is determined to delever and reduce spending, the government must respond by issuing enough securities to fund a volume of investment spending that will fully utilize all available resources.  In doing so, it will simultaneously work to accommodate the private sector's desire to save by issuing safe government securities.  Otherwise, it is far from certain that a developed market economy will self-correct through the private sector alone.  Depressed interest rates, far from being a tool to incentivize private sector leverage and spending, are symptomatic of weak expected economic performance partially as a result of the private sector's desire to restore its net worth by cutting spending (saving) and their use of leverage.

*The Fed does not need to increase their policy rate for monetary policy to (passively) tighten in an environment where the neutral rate is declining.  The obverse of this being that the Fed does not need to cut their policy rate to allow for monetary accommodation as long as the neutral rate is rising in relation to the Fed's stance.

**The Federal Reserve’s Balance Sheet as a Financial-Stability Tool

"Reducing the IOR-RRP spread, and shifting the Fed’s funding mix to the more open and competitive RRP market, would potentially create social value in two related ways. First, and most obviously, it would save taxpayers a meaningful amount of money. With over $2.5 trillion of reserves outstanding, even a modest 10 basis-point reduction in the Fed’s total funding cost amounts to $2.5 billion of taxpayer savings per year. Moreover, these savings effectively come directly out of the rents earned by banks—to a large extent foreign banks—as a result of the imperfectly competitive and frictional nature of the market for reserves. Second, this taxpayer savings is the flip side of a more efficient allocation of the Fed’s liabilities to those who value them most at the margin—i.e. money market funds in this case, as opposed to depository institutions."

"Moreover, in a world where the Treasury’s issuance of the shortest-maturity bills is insufficient to fully satiate this demand for money-like claims, the resulting money premiums at the front end of the curve create a strong incentive for private-sector intermediaries to fill the void and replicate something like one-week bills, for example by funding themselves with overnight repurchase agreements or short-maturity asset-backed commercial paper. 

This observation suggests a potential crowding-out motive for government debt maturity. In previous work, we and others have documented that when the supply of T-bills increases, this front-end money premium declines in magnitude, and private-sector issuance of short-term paper declines. In other words, when the government creates more in the way of short-term safe claims, it reduces the incentive for the private sector to step in and manufacture such claims. Given the systemic-risk externalities associated with private-sector maturity transformation, we argue that it is desirable for the government to be an aggressive supplier of safe short-term claims, thereby encouraging private firms to lengthen the maturity structure of their own funding."