OMF - Overt Monetary Financing
Helicopters Can Be dangerous 02-17-13 Financial Times Gavyn Davies
The FT recently called for a serious debate on the idea that budget deficits should be permanently monetised by the central banks. So far the most prominent response from an active policy maker has come from Lord Adair Turner, the outgoing Chairman of the UK Financial Services Authority, and a former candidate to become Governor of the Bank of England .
Lord Turner is under no illusion that his discussion of this policy option will open him to ridicule or worse in some quarters. He expects to be called a “dangerous man”, which is a strange description for this typically cerebral product of McKinsey. Yet he considers this risk worthwhile because he believes there should be a rational comparison between OMF or overt monetary finance (a less inflammatory term than the usual “helicopter money”) and the quantitative easing favoured by today’s central bankers.
In public, central bankers like Ben Bernanke, Mark Carney and of course the entire ECB remain firmly opposed to this idea. But it is probably being implemented in Japan, and I have been surprised (and worried) at the willingness of mainstream central bankers in the US and the UK to contemplate the option in private. This blog serves as a reminder of the serious dangers involved.
The Difference Between OMF and QE
If implemented as stated, there is little difference between QE and OMF in the short run, but a very large difference in the long run.
Both policies involve the purchase of government debt by central banks to finance budget deficits, using newly created bank reserves to finance the purchases . The key difference is that in the case of QE, the bonds are (in theory) only parked temporarily at the central bank, while under OMF the purchases are never intended to be reversed. This means that the increase in the monetary base is temporary in the case of QE, and permanent in the case of OMF.
A second difference is that, in the Turner version of OMF, there is also a deliberate rise in the budget deficit, compared to what otherwise would have happened. This means that the policy requires co-operation between the fiscal and monetary authorities, while QE is built around the proposition that the two policies are determined at arms length.
In theory, QE involves no increase in the budget deficit, only a different form of financing for a given deficit. However, the Turner version is not the only possible formulation of OMF. It is possible to leave the budget deficit unchanged in both cases and simply focus on the difference between financing methods.
Under OMF, the ultimate link between budget deficits and public debt is broken. (Money does not count as debt.) In contrast, this link is maintained under QE, because eventually the private sector needs to repurchase the bonds held by the central banks.
This means that the private sector must assume that its savings will one day be tapped to fund budget deficits under QE, while savings will never be tapped under OMF. The breakage of the link between the government’s decision to run a budget deficit, and the public’s willingness to finance deficits at acceptable interest rates, removes the critical discipline which markets impose on governments. You do not have to be a fan of Machiavelli to believe that this might end badly.
Because it does not tap private savings, OMF financing will be much more expansionary than QE on a dollar-for-dollar basis. Supporters of OMF, like Lord Turner, see this as an advantage, and say that it means that the medicine would need to be applied in much smaller doses than QE. The possibility of introducing OMF in small doses, controlled by the central banks, is seductive: supporters argue that not all roads necessarily lead to Zimbabwe.
Lord Turner argues that permanent money financing of deficits has an impressive intellectual lineage, including Chicago economists Milton Friedman and Henry Simons. However, it is more normally associated with the work of Abba Lerner, a radical economist who departed the LSE for the US in 1937 and gained notoriety by arguing that the financing of budget deficits should be determined only by the impact it has on inflation and interest rates, with no a priori preference for bond financing over monetary creation as the normally preferred method. Lerner’s writings, which are sometimes regarded as more Keynesian than Keynes himself , have inspired the school of modern monetary theory which thrives nowadays on the web.
However, today’s leading Keynesians like Paul Krugman differ from the MMT school, because they believe that in the long run, once the economy has escaped from its current liquidity trap, the monetary base must be brought back to normal, following a period of QE, in order to prevent inflation rising. Furthermore, they tend to believe that the stimulative effect of budgetary policy is measured, to a first approximation, by the size of the budget deficit, and not by the form in which it is financed. Finally, they do not worry much about the stock of public debt, or about Ricardian equivalence, so they are not attracted by financing methods which create money in order to hold public debt down.
The traditional concern of central bankers is, of course, that the permanent monetisation of budget deficits will lead to an unhinging of inflation expectations. That is not exactly an original objection, but it cannot be swept under the carpet.
Lord Turner responds as follows. He believes that all forms of monetary or fiscal stimulus, conventional or unconventional, work by increasing nominal demand in the economy. Once demand is increased, the split between higher prices and higher real output is determined separately, according to whether there is enough spare capacity to allow real output to expand in line with the extra demand. The particular method used to increase demand is independent of how inflation responds to the monetary stimulus.
Turner prefers to choose a method which he knows will be successful in boosting demand, rather than worrying about the different inflationary consequences of different methods, because he does not allow much role for inflation expectations to be affected differently by OMF compared to QE. But there is the rub.
In both monetarist and new Keynesian models of the economy, permanent monetisation will eventually produce higher inflation , although “eventually” may refer to a very long time indeed. It is much more likely that inflation expectations could rise markedly under permanent monetisation and, in my view, that is not a price worth paying for (perhaps temporarily) higher output.
Does that mean that no-one should ever contemplate using permanent monetisation? Well, never is a long time, encompassing many possible scenarios. Adair Turner and Martin Wolf make a very convincing case that Japan cannot find any other way out of the public debt trap into which it has fallen, except default or deep recession. Japan needs actively to raise inflation expectations. But neither the US nor the UK are anywhere there yet.
 Lord Turner’s analysis can be found in a detailed speech here, or in an interview with the FT here. Martin Wolf provides a sympathetic response here.
 The central bank does not have to buy bonds in the open market; it could also credit the government’s bank account in exchange for treasury bills, allowing the government to pay cheques directly to the public.
 A really interesting short article on the relationship between Keynes and Lerner, written by David Colander in 1984, explains that Keynes adjusted the public statements of his views so that they would be more acceptable to the political establishment. Lerner, in contrast, followed the logic of Keynesian economics remorselessly to the final destination. Some people may think this is what is happening today with helicopter money. Lerner’s most influential articles on this topic from the 1940s are here and here.
 Printing money by central banks is called seigniorage. In theory, there is a “safe” amount of seigniorage which any central bank can do without causing inflation, since the public’s demand for the monetary base will grow in line with nominal GDP. This has led to suggestions that the central bank can print money today up to the limit of its future “safe” limit of seigniorage, without causing inflation. This suggestion requires a more detailed discussion at a later date, but in my opinion it does not prevent inflation expectations from rising if OMF is introduced.